October 15, 2009

This week we take a hard look at gold. 

Gold has become a bigger and bigger story over the last several years as it’s steadily surged toward new peaks, just a week ago summiting an all-time high of $1,058 per ounce.  This has dovetailed in perfect synchronicity with increasing fears about inflation, concern about the strength of our national currency, and uncertainty about our collective economic future.

Now’s as good a time as any to drill down and separate myth from reality.  As usual, what we have to say may not be what you’ve heard elsewhere.  We like to take a contrarian perspective on the world, though certainly not just for the sake of being contrarian.  Fundamental correctness is absolutely paramount to any contrarian viewpoint.  We are firm believers that when it comes to macro investing, the best way to make real money over the long run is with a stance that is both contrarian and fundamentally correct.  Being contrarian is easy (though not as easy as you might think), but being correct is hard.  There is a lot of money to made from situations where most of world has it wrong and you have it right.

Gold is probably the one thing we get asked about the most.  When we meet people out in the world that find out that we trade commodities, they almost invariably ask us what we think about gold.  Most people that you talk to tend to have an opinion about it.  Unlike stocks and especially bonds, investor sophistication has little to do with an individual’s opinion of gold.  Quite simply, everybody wants it.  They have for millennia.  What’s more is that they understand it innately.  The want is almost primal.

Gold has been demanded and desired by basically every civilization in history.  It’s been used as a store of wealth throughout the ages.  At various times in various economies in history it’s been used as a medium of exchange, either directly, or indirectly as a hard asset backing a paper currency.

Understanding all this historical and psychological context is important before we get down to the nitty gritty.  When we begin looking at gold, and more importantly, begin using gold as a tool, it’s important to keep all the noise at bay.  We need to look at it objectively.

So here we go, the first three things you need to know about gold:

1) It’s not the inflation hedge you think it is.

In the past gold hasn’t actually correlated very well with inflation.  Gold went pretty much straight down from the frenzy peak in 1980 until about 2001.  That was a period of unquestionably positive, albeit modest, inflation.  If you bought gold in the 80’s to hedge against future inflation, you lost money on both sides – not exactly the kind of result one is looking for in a hedged trade.

Over the long, long run gold has worked as an inflation hedge.  But a lot of things have gone up in value over the last century and have thus have correlated positively with inflation.  In the 20th century, just about everything that was denominated in dollars went up in value as the value of the dollars denominating them went down.  So over the long, long run, it’s not really much better a hedge against inflation than equities or real estate or other physical assets.

You might also be curious if gold can predict future inflation.

The below chart looks a little confusing at first but it really isn’t so bad.  All it does run back through history, stopping at each month to look back at the previous 12 month change in the price of gold and chart it against the next 12 month change in the inflation rate (as measured by the CPI).

So each dot represents one month and it measures the prior year’s change in the gold price versus the coming year’s change in inflation.  I also did it for a 6-month interval as well.

Make sense?  We now can ask:

The answer is… sort of.

It’s pretty clear to see that the slope of the regression lines are both positive which means that there is indeed a positive correlation between past movements in gold and future movements in inflation.

But during normal times i.e. annual inflation between zero and 5%, movement in gold does a very poor job predicting the rate of inflation.  Perhaps because normal times are boring.  Nobody cares about inflation in the low single digits.  That is what the Fed is actively shooting for, after all.  Central bankers around the world sleep soundly and have happy dreams if inflation is positive and low.

What investors want to know is if there’s a way to forecast hyperinflation.  And here you can see that when gold has really gone wild, increasing by 100% or more in 6 months, it has usually meant that high single-digit or double-digit inflation has followed in the next 6 months.  It does a little better job as a predictor here, but keep in mind that just about all of those data points towards the top right corner in that chart were from the late 70’s and early 80’s.  The gold market was held in the grips of a speculative frenzy and the country had already been experiencing double-digit inflation for years.  So none of those data points would have been particularly useful in practice.

The take-home point here is that one should be careful when looking at the gold market and using its movement to divine the future.  Yet again, we bump up against the ubiquitous conclusion that past performance is not indicative of future results.

Gold’s up around 20% in the last 12 months which is a big move, but you can see that very little should be excluded from our expectations of the change in coming the inflation rate.  Pretty much any outcome is in play.

2) It’s best thought of as a “neutral currency”.

The most important thing to understand about currencies is that they are a relative value proposition.  Currencies don’t have an independent, absolute value the way other assets do.  Instead they are globally priced in terms of other currencies.  Or even other assets, which can be a little counter-intuitive.  I went to the grocery store yesterday and there was a big box of pumpkins outside where they were strangely pricing dollars in terms of pumpkins.  The sign said $1/4lbs pumpkin.  Apparently one dollar is actually worth 4 pounds of pumpkins.  How many pounds of pumpkins does one ounce of gold cost?  About 4,260 pounds of pumpkin!

As I’m sure you’ve noticed, economists have a strange sense of “humor” and one thing we like to do for fun is price one thing in terms of another thing.

It’s especially interesting to use gold for this.  For example, let’s price the stock market in terms of gold.  The first chart is log scale, the second is linear scale:

There are a lot of ways to interpret those charts.

When priced in terms of a “neutral currency”, the dot-com market bubble really stands out.  That was an epic bubble, folks.  What’s interesting is that the stock market’s second run back towards new highs in 2007 wasn’t really an equity bubble at all.  It wasn’t even really a bull market.  To somebody that used gold as their currency – or even a lot of other foreign currencies – the highs in 2007 were just another stop on the way down in a gigantic bear market.  That second little peak in the stock market was actually due to dollar weakness!

Here’s a chart of the Dollar Index (DXY) which measures the value of the US Dollar against a basket of foreign currencies:

Kind of remarkable, no?  The dollar is on balance about 35% less valuable relative to a basket of other major currencies than it was at the beginning of this decade.

In the summer of 2001 I went backpacking through central Europe, pretty much at the exact peak in the USD.  At the time I was astonished at how cheap everything was over there.  Hostels in Germany and Austria were only $5-10 dollars per night, while a very nice bed & breakfast in Venice cost me about $60.  Greece was ridiculously cheap and the (wonderful) food was only slightly more expensive than “free”.

I returned to Europe in the summer of 2007 – not quite the low in the US Dollar, but pretty close.  Needless to say, the experience was substantially more expensive.  My dollars didn’t take me nearly as far, but fortunately I had a couple more of them to offset their loss in global purchasing power.

Unless you travelled beyond US borders, you probably haven’t noticed such a drastic change in your own purchasing power in the last decade.  Most people don’t have a very good sense of how valuable the dollars we hold in our bank accounts are relative to other currencies and assets.  But if you’ve owned gold, effectively a neutral, global currency, you’ve noticed it trend straight up and a big reason is the decrease in value of the dollars in which it’s denominated.

The point here is that since it’s priced in dollars, gold is very dependent on the relative value of those dollars and the future price of gold is inextricably linked to the fate of the world’s paper currencies.  Dollar-denominated gold will perform much better when the US Dollar is under substantial pressure.  Dollar strength typically tends to be a fairly large headwind for gold.

The difference is subtle, but Gold is your hedge against dollar weakness, not inflation. 

3) Trading it will drive you bonkers.

Like I said a few months ago: Gold never moves the way you think it will.  It never tells you what you think it’s telling you.  And it does strange things for even stranger reasons that no sane person can hope to understand.  Investors who own gold for the long haul love it, but I’ve yet to meet the trader who hasn’t been driven completely insane by the gold market at some point in his career.

The reason why it’s so tough to trade is that it’s so difficult to predict where gold is heading over the short run.

Does that chart keep moving higher over the next few months?  It looks like an easy answer, and were it anything other than gold, I might take a shot at answering it.

Over the long run, it’s easy.  Gold will exhibit inverse correlation with the dollar and over the long, long run the dollar is a sure bet to get weaker relative to the amount of goods that it can purchase.  I think the single best bet an investor can make today is that 100 years from now each US Dollar will buy substantially fewer goods & services and be worth substantially less against a hard asset like gold.

Check this out:

The red lines measure the trailing 1-year inflation rate.  The green line, measured on the right axis, shows the purchasing power of the dollar.  Today each US Dollar is worth about 96% less than it was worth in 1900.  You can see that dollars are a bad investment over the long run, and incidentally, this is why people demand interest when holding dollars on deposit at a bank.  If I’m going to let you hold one of my dollars for the next year, you’d better give me more than my one dollar back a year from now because I can be fairly confident that that one dollar will be a little less valuable relative to what it can purchase. 

The more inflation that’s expected, the more interest that’s demanded.  This is why it’s usually a little better to look at something like the bond market to get a read on future inflation than the gold market.

Gold doesn’t necessarily go up when inflation is expected and it won’t necessarily rise with to the degree to which inflation is expected.  Sometimes it does.  But usually it doesn’t. 

Interest rates are a much better indicator here.  They typically go up when inflation is expected, and the more they go up, the more inflation the market’s expecting.  Predictable reactions like this make bonds a whole lot easier to trade than gold.

Market Recap

Along the subject of a weaker currency, the Big Dollar Trade – selling short the US dollar – is back on in a big way in Hedge Fund Land.  A lot of hedge funds made a lot of money on this trade from 2002-2004 and they’ve been putting it back on this year in a variety of different ways.  Some funds like John Paulsen have been acquiring gold, others have been buying foreign currencies, while others like Jim Rogers have been loading up on physical commodities. 

Housing

This caught my eye the other day.

"Hundreds of thousands of home buyers have come off the sidelines because of the [new homebuyer] credit, and if we lose it we risk losing the stability that is creeping backing into the housing market and the economy overall," said Robert Story Jr., a Seattle
mortgage banker and the incoming chairman of the Mortgage Bankers Association.

Wow.  That sounds strangely like the twisted logic of drug addict.  “Don’t take away my drugs, man!  I need my drugs, man!  You wouldn’t like me without my drugs!” 

My generally skeptical view of a robust housing recovery aside, I have mentioned several times over the last few months that we are all becoming dangerously addicted to and uncomfortably reliant on government stimulus to consume.  This is something that should make people concerned about the true state of the economy instead of optimistic.

At some point the drugs have to be taken away, right?  I mean, we can’t perpetually give people free money to buy a house.  Eventually we’ll have to stand on our own and deal with the effects of withdrawal.  And what do we know about withdrawal?  It’s painful.

But there’s serious talk about extending that new homebuyer credit, and the smart money says it probably will be.  Thank goodness – looks like we’ll get one more hit!

That’ll be a good thing for the housing market over the short run, but probably a bad thing for the long run as it works through the withdrawal symptoms.  You can read more about my thoughts on housing here.

Dow 10k Redux.

The last week has been a great one for stocks and the Dow crossed above 10,000 yet again.  Who in the world back in 1999 would have thought that the Dow would cross above 10,000 for a fourth time over ten years later?  Something tells me that this won’t be the last time we cross above or below this meaningless milestone.

Traders, I certainly wouldn’t get short at this point in the market, but I’d take any profits from trades I’d put on in the last two weeks and look to reload on any significant pullback.  Fighting the trend at this point is foolish, but don’t mistake that for an endorsement of stock returns over the next several years.  The recession is over and the market has rejoiced at that prospect.  But winter isn’t over yet.

That’ll do it for this week.  Next Thursday we’ll return with Three More Things You Need to Know About Gold.  I can’t wait – this is exciting stuff!

See you then,

—

Feedback@TheDraconian.com
Subscribe to the Newsletter by Email
Read the Legal Disclaimer

—

October 8, 2009

This week we cover some interesting ground and begin with a short lesson on economics.  If the mere thought of an economics lesson makes you drowsy, stay awake! Go pour yourself another cup of coffee.  This is extremely important stuff to understand because in this lesson are the answers to a very important question: “Is another crash coming?”

Now I’ve got your attention!  Don’t worry, I promise not to let things get too technical.

Welcome, new readers from the Reno Gazette Journal.  The Draconian is being syndicated in the blog section over at RGJ.com.  Those of you readers who aren’t yet familiar with our firm can learn a little bit about us here and this website there.

We’re also developing a dedicated iPhone app, but in the meantime I installed a backend iPhone application in WordPress.  If you direct your iPhone Safari browser to TheDraconian.com you will see a specially formatted web view that’s really easy to read when you’re on the go.  You’ll even get a snazzy orange dragon and one-touch access if you bookmark it to your home screen.

Away we go…

Market Recap

One week ago exactly I mentioned that it was a great time to buy the market for a short term trade.  Had you bought the market on Thursday’s close at about 1030, you’d be up almost 4% on that trade through today.  Not bad for one week.

Sometimes I get lucky and nail these things spot on, but the fact remains that the secondary trend in the market is bullish, which means that traders should be buying on weakness.  In practice, it’s a lot harder to actually buy into weakness than it sounds.  On days when everything seems to be going down it’s very tempting to “wait and see” – emotion is a lot tougher to ignore than many give it credit for.  Often, the toughest trade winds up the best one.

We actually did buy the market on Friday’s open in one of our funds, and I’ll admit it was a little hard to do because so many talking heads were thinking that the market was on the verge of rolling over.  Fortunately as systematic traders, we’re able to place a lot of faith in our signals and can avoid much of the emotion of trading.  We grabbed the low, sold at the high a few days later, and it wound up being a dynamite trade.  Now we patiently wait for the next opportunity.

It doesn’t always go so smoothly.  We certainly have our share of stinkers too.  But bad trades are a whole lot easier to deal with if you clearly define your risk before entry and set precise targets and conditions for exit.  Making the occasional bad trade is a simple fact of life as a trader.  Nobody gets ‘em all right.  However, not allowing bad trades to fester into disastrous trades is something a trader can control, and this discipline is what separates the good traders from the bad.  The classic example is Average Joe, who buys stocks in the midst of a speculative bubble, holds onto them through the peak, and refuses to sell as the market falls further and further, all the while thinking “things have got to come back eventually!”  The poor guy had no good reason for getting in and no plan for getting out.

Also of interest in the markets this week was the 10-year TIPS auction (Treasury Inflation Protected Securities) on Monday which showed very strong demand with a bid-to-cover ratio of 3.12.  It’s not an immediate indicator that inflation is on the horizon, but it is indicative that there is strong demand to pick up some insurance against future inflation just in case.

TIPS are a great hedge against inflation because their principal adjusts with the consumer price index.  If you own TIPS and the CPI goes up, the face value of your bonds go up!  Pretty cool, huh?

The bad news about using TIPS as an inflation hedge stems straight from the CPI.  The CPI is the most popular way of measuring inflation, but to say that it’s criticized by certain folks out there in the market is a massive understatement.  Critiques range from a simple understatement of true inflation to some radical voices that claim it’s outright fraudulent in its methodology.  The Bureau of Labor Statistics take a lot of heat for the way they calculate it and the numbers they come up with.

There’s usually more grumbling about the CPI during inflationary periods, especially when the prices of things like gasoline and physical goods rise sharply.  Individuals and small businesses feel the effects of those price changes very acutely and when the CPI doesn’t keep pace with those increases, these folks perceive it as though a great injustice is being perpetrated against them.  When inflation is low, nobody seems to have any beef with the CPI.

Anyway, we still think that price inflation will run cooler than a lot of people are expecting.  Of course that thesis is predicated on a tepid recovery or even a double-dip recession.  If the GDP growth we see in in Q3 and Q4 this year really takes hold and it looks like the economy will definitively firm up in 2010+, it will certainly be time to revisit that forecast.  But right now the bond market is telling us that the economy is weak and the Inflation Chupacabra is nowhere in sight.

A fresh look at Capitalism

One of the side effects of the changing political tide of the last year and historic government intervention is that capitalism is being reshaped before our eyes.  It’s still all about the pursuit of profits and taking risk, but part of what makes Capitalism work in both theory and practice is that failure carries real penalties.  When the penalties are paid by somebody else – as they have been in the case of bailouts past and present – then the costs associated with taking risk disappear.  Everyone (or everyone large enough to qualify for a bailout) immediately develops the incentive to take a lot of risk.

“Capitalism without failure is like Christianity without hell.”
– Warren Buffet

Free market capitalism isn’t free market capitalism if there’s a net.

This isn’t actually a bad thing, per se.  It just means that our capitalism in practice is intellectually impure.  Again, that’s not a bad thing on its own.  It just means that it won’t work the way it works in the textbooks and nobody should expect it to.  Capitalism with a net sounds like a self-sustaining, self-regulating, stable system, but it’s actually inherently unstable.

For the reason why, we turn to the economist Hyman Minsky.  I’ll boil down Minsky’s view of capitalism as follows:

Imagine a brand new economy, one starting from scratch or maybe getting back up on its feet in the wake of a depression.  You and I found our businesses on sound business plans, with well thought out methods for generating profits and free cash flow.  Our businesses and others are pretty conservative as a whole.  Borrowers and lenders steer clear of risky stuff.  Profits arrive on time in a predictable manner and what debt there is in the system always gets repaid.  Our imaginary economy grows steadily.

All this success now starts to breed a little more risk as businesses hope to boost their profits.  We are reminded of Ricky Jay’s memorable line in Mamet’s The Spanish Prisoner, “we must never forget that we are human, and as humans we dream, and when we dream we dream of money.”

There is no better framework in the world to pursue that dream than capitalism.  After years of prolonged success, more and more of us forget that failure is a possibility and we all get more and more comfortable taking more and more risk.  The economic profits now really start to roll in.

Eventually our hypothetical economy and all its success starts attracting what Minsky termed “speculative borrowers,” people or businesses who take on lots of debt to participate and whose income might be able to meet the interest payments on that debt but not the principal.  All these profits also start attracting “Ponzi borrowers,” people or businesses who rely on financing to participate and whose income isn’t sufficient to cover either interest or principal payments.  Instead, these folks rely on ever more borrowing to pay their bills and service their debt.

What was once a conservative, soundly profitable economy has now become a very risky one dependent on cheap, easy credit.  Our economy might still be very successful, and it might only have been possible in a capitalistic framework, but it is now extremely vulnerable to shock and panic.

The famous “Minsky Moment” occurs when an exogenous shock leads to an economy-wide pullback in credit.  Speculative and Ponzi borrowers are the first to implode as their credit is pulled and their sole means of participation vanish.  More conservative individuals and businesses suffer too as they start selling assets to pay off debt, the sales of which drive prices lower and lead to further reduction in systemic credit.  Legitimate businesses start blowing up and everybody stops spending money at once.  Now the broader economy starts suffering as its thrown into recession.

Sound familiar?

Solutions to the problem

It shouldn’t surprise you to hear that Hyman Minsky – an obscurity for his entire career – is suddenly, almost magically, quite popular.

He did most of his work in the 1960s, a time of stable economic success, so it’s no wonder people thought he was crazy.  Everybody thought he was nuts in the late 90s as well.

Now that he has the world’s economic ear, let’s examine his proposed solutions for these inevitable crises of capitalism.

First, Minsky believed that the Fed would need to step in and act in accordance with its mandate as “lender of last resort”, loaning money on generous terms to pretty much anything of significant size that needed it.  Mission accomplished.

Second, he thought that the government, which he actually referred to as – Republicans, cover your ears – “Big Government,” should step in and act as the employer of last resort, handing out a job to basically anyone who wanted one at a pre-set wage.  Today the government has done what it can within the realm of political feasibility to create some new jobs, but guaranteeing a job to anyone able and willing to work is a pretty radical, socialistic idea.  As you may have noticed, we’ve taken the Keynesian path instead.  I talked about that here in case you missed it.

Ultimately, Minsky believed that there was no answer, no cure for the inherent ills of capitalism.  Stability, profitability, instability, and loss are as unavoidable as the seasons. Here in October we all know that winter is coming, but instead of trying to rig up a false world of permanent summer, we simply brace ourselves for the change in weather.  We know winter eventually passes and so next spring we’ll sow seeds in our garden with the confidence that they’ll grow.

It’s tough breaking free from the linear frameworks that dominate Western/Judeo-Christian thought, but during times like these, we all might derive a little peace from simply appreciating the cyclicality of life and the world that surrounds us.

Before I drift off into philosophical reverie, let’s bring it back to reality…

The Minsky Moment happened already

The crisis already happened last fall.  Credit contracted, speculative borrowers wiped out, and it dragged the economy deep into recession.  To get a historical read on that, we take a look at the LIBOR-OIS spread.

I know – “LIBOR-OIS spread” sounds complicated and wonkish, but it’s basically just a measure of how banks feel about each other.  When it’s high, it means that banks doubt each others’ creditworthiness and won’t lend each other money.  When it’s low it means that banks trust each other and they’re happy to loan each other money.

(Techie note: LIBOR-OIS measures the spread between the London Interbank Offered Rate and an overnight indexed swap of the Fed Funds rate.  It’s used with its more-friendly named cousin, the TED Spread, which is the difference between the interest rate on 3-month U.S. Treasury Bonds and 3-month Eurodollar contracts.)

It’s a great measure of risk and liquidity in the markets.  When used in conjunction with the VIX and VIX futures (the CBOE Volatility Index) even a novice investor can get a very accurate, very sophisticated read on the level of risk and fear in the marketplace.

It’s really simple to interpret these things too.  When they go up it means more risk and when the go down it means less risk.

In the chart above you can see that last October banks were pretty freaked out about each other.  Historically freaked out.  The stock market crashed as a result and the financial system ground to a halt.

You’ll also notice that there were indications of stress and an increase of risk in the credit market as early as August 2007.

I’ve mentioned before that our real business is actually not newsletter-writing (no surprise!) but portfolio management.  We conduct our own proprietary trading and also manage a fund of hedge funds.  You can find information on all that here.  August 2007 was exactly when we started noticing strange behavior in Hedge Fund Land.  Many of the most highly-leveraged hedge funds suffered disastrous performance that month and several of their managing firms were put out of business as a result.  These hedge funds were the proverbial canaries in the coal mine.

But today things look OK on the credit front.  Hedge funds as a whole lost money in 2008, but dramatically outperformed the market.  They’ve underperformed a bit in 2009, but as a whole they have been making decent money and we haven’t noticed any anomalous behavior, anything outside the realm of what one should normally expect in a normal environment.

Rest assured, I’ll inform you all immediately if I see anything potentially scary happening in the Hedge Fund Land.

Reading between the lines, you might take all that as an endorsement of the market.  But let me be clear, it’s more of a gentle reminder that this crisis has passed.  It’s over.  That’s not to say that a separate crisis isn’t lurking around another corner later this decade or that the stock market won’t deliver disappointing returns over the next several years.  I think those are both likely possibilities in 2010 and beyond.  It’s also very likely that should another crisis transpire, it will be of a very different type.  It could involve emerging markets, another war, a total breakdown in global trade, maybe even a shift in domestic fiscal policy – who knows.  I wish I could tell you what it will look like.

Winter consists of many storms.  The first might drop several feet of snow.  That snow will melt and the next storm might bring icy rain or possibly a dry week of sub-zero temperatures.  No two storms are exactly the same.  If we can be sure of one thing it’s that the next crisis will look a little different than the last.

This is tremendously relevant because if you think the market or the financial world is going to completely fall apart tomorrow or next week the way it did last year, know that the odds at present are slim.   Trying to trade around that thesis could prove dangerous.

Investors should be using this current reprieve to consider alternative investments and rebuild their portfolios in a manner that’s much better equipped to deal with range-bound markets and slower economic growth than we’ve grew accustomed to during the long boom.  Stick a fork in “buy ‘n hold.”  At least for a substantial while.  (How’s that for a vague forecast?)

Viva la Revolución?

Yes, a major populist movement is underway.  Yes, the next twenty years will be about rebuilding the middle class – not totally to the detriment of the rich or to the benefit of the poor.  Yes, the government is flexing its muscles amidst an epic bull market in politics that will likely run for the next decade at least.

But captalism isn’t going away.  There is basically zero talk in academic circles about serious alternatives.  Michael Moore can call it “evil” and tug at all the heartstrings he wants in his own ironically-capitalistic pursuit of profits, but competition, economic individualism, and free-ish markets are here to stay.  Did we learn nothing from the era of glasnost?  It wasn’t that long ago!  Free economies are superior to centrally planned ones.

The future will be about ways to make capitalism safer.  And we’ll do it, too.  I know this because we’ve done it before, back in the 1930s.  More regulation and more stable markets will eventually emerge and systemic credit will pull way back.

When stability does re-emerge it will immediately start to breed – you guessed it – more risk.  It’s hard to fathom today, but a decade or two from now the good times will return and we’ll all feel more optimistic about the future of our country than we have since the 1950’s, or even the post-Civil War Reconstruction.  But once we get there, the slow march towards the next Minsky Moment will be on.  The cycle of re-regulation and de-regulation will continue.  Stability breeds instability.

Intellectually pure capitalism does avoid this endless cycle, but pure capitalism is pretty tough to stomach in practice.  Hardcore Libertarians like myself may love it, but the sad truth is that it’s too darn scary for most people.  The cost of failure can be total and the variance in wealth distribution can be extreme.  Instead we have capitalism with a net and a bunch of regulation, which isn’t so bad, provided we understand how and why it works and gauge our expectations appropriately.  Many difficult problems in life aren’t intrinsically difficult, but rather generate a lot of difficulty because we had inappropriately aligned expectations.  For the curious, the world of Eastern philosophy does offer plenty of guidance on that, but alas, this is not a philosophy newsletter.

Here in the Sierras, we are highly attuned to the weather.  There’s probably a deeply-rooted biological reason for that, but we know the instant we feel that first chill in the air that change is coming.  We might not know if its our snow parkas or our galoshes that will be needed in the coming months.  A fuzzy sweater may even suffice.  But we get our expectations ready.

We put the shorts and sandals away until winter has passed in full.

—

Feedback@TheDraconian.com
Subscribe to the Newsletter by Email
Read the Legal Disclaimer

—

October 1, 2009

Today we’ll look at the economic recovery and what shape it’s likely to take.  Then we’ll look at our forgotten friends, the Japanese and wonder if we’ll get a zombie (bank) outbreak stateside as well.  It should be exciting stuff.

But first, a welcome to all the new readers!  The Draconian is now also being syndicated over at the Reno Gazette Journal on their website, RGJ.com.  Updates over there will be lagged by a few days, and you should be able to find it on Monday mornings in the middle of the front page under the “Reader Blogs” section.  Just look for the orange dragon.  You can also go straight to the The Draconian’s RGJ blog homepage here.

Market Recap

The market took a little breather this last week.  With the exception of yesterday (the month-end) volume has been even lighter than usual.  Normally, I like to see volume confirm the market’s direction.  Over the short term, stocks have sold off on weak volume in the midst of a very bullish secondary trend.  I wouldn’t be surprised to see a quick rally for a week or so to retest or break the highs of last week.  A day like today is a great day to do short term tactical buying.

Over the long term, stocks have been rising on generally weak volume in the midst of a very bearish primary trend.  I wouldn’t be surprised to see the market reverse course and trend lower in the next six months to a year.

Also of interest over the last week were declining consumer confidence numbers for September, not the kind of thing one wants to see heading into the holiday season.  The market has been telling a very powerful story over the last six months, and I think the story that it’s been telling is “we all had it wrong and the world wasn’t going to end the way we thought it could after March” not “robust economic growth is in our future.”  This story will be confirmed if stocks flatten out or trend lower over the next year.

Gold continues to receive a lot of attention as it bounces around $1000/oz, but what is much more worthy of your attention is the U.S. Dollar.  The Dollar Index (DXY) has rallied over the last week which only adds to my skepticism that the undeniably strong market we’ve seen is signaling a strong economy to come.  What would make me much more bullish on the market and the economy – especially from here – would be to see the market advance alongside a strengthening dollar.

Bonds performed well in both September and August, and I think there are two interesting reasons contributing to that.  The first is that I believe more and more people are waking up to the notion that all the crazy inflation that so many thought would be in store may not be so crazy-inflationary after all.  The real story for the next few years looks a lot more deflationary/disinflationary than most thought.  We were, of course, relatively early to that party.  I still think the blueprint we set forth in that piece is relevant for the years to come.

A changing appetite for risk

Secondly, I think there might be a quiet reallocation of risk taking place as investors of all shapes and sizes begin to get kind of excited about boring ol’ bonds.  Pimco, manager of the world’s largest bond funds, has taken in a staggering amount of money in recent months and they aren’t the only bond shop to see heavy inflows this summer.

More broadly speaking, this ties beautifully into what I think will be two coming decades of a country that is generally less comfortable taking risk than it was in the prior two decades.  A major demographic change is afoot.

Boomers, on the doorstep of retirement, are quickly coming to the realization that they cannot afford to take the risks they did in midlife and they will use their loud, influential voice to champion the reduction of risk in matters public and private.  This is already happening in Washington, as Boomer legislators train their focus on increased regulation and protection.  They’ve done this in the same obnoxious, passionate manner that they used to rebel in the 60’s & 70’s and tear down barriers to free-enterprise in the 80’s & 90’s.  Their obsession with the future will lead them to reshape it as one that is safer for them and those to follow.

Gen Xers, risk-takers-extraordinaire, are quickly becoming consumed by their skepticism and distrust of institutions and “The Man.”  Their pragmatism is already getting the best of them as they embrace anything that works and shun anything that doesn’t.  The alternative asset industry is dominated by Gen X and many of the sharpest critics of buy-and-hold as an investment strategy are thirty- and early fortysomethings.  At present they are the engine of the private enterprise machine and transition is now underway as Boomers hand them the keys.  Their detached practicality will reshape the world.

And Millennials, still in school and new entrants to the workplace, will step up with their teamwork and collectivism.  They will rise to the challenges that the elder generations will set forth.  The young bought in to President Obama’s idealism hook, line, and sinker and were one of the most important factors in his landslide election, which today in so many ways appears as though it was one of the most inevitable events in modern history.  Millennials have little money so they won’t shape the markets directly, but rather indirectly.  Their desire to bring society together will be catered to by elder generations that will no longer ignore the incredibly-human need to try and make life better for our children.  There’s a lot wrong, so it will take time.

I’ve been a fan of Neil Howe’s work for a long time.  If this generational stuff sounds interesting to you, he has books you can check out and a website, lifecourse.com that’s worth a look.  The Fourth Turning changed my life and how I see the world but your mileage will undoubtedly vary.  I’m a sucker for abstract, big picture concepts.

For those a little more interested in details they can make use of, read on!

The Shape of Things

V-shaped?  U-shaped?  L-shaped?  Surely, you’ve heard these terms thrown around.  It happens every time there’s a contraction in GDP, and they’re used to describe what path the subsequent recovery will take.  Talk of a W-shaped recovery is also very popular today.  Stranger ones include X-shaped, square-root-shaped, and also sorts of other funky letters and phrases used to describe what the recovery will look like.

Let’s take a look at a chart of gross domestic product since 1929:

I don’t see any U’s or L’s or X’s or much of anything else.  Do you?

Most of us think of things in nominal terms, that is to say we don’t adjust them for inflationary effects.  It’s tough to see on that chart above, but if you click it to enlarge, you’ll notice that the only type of recoveries we’ve ever seen have been V-shaped recoveries.  The economy contracts, GDP falls until a certain point, and then it starts going back up again as the economy resumes its positive growth path.

You’ll also notice that in nominal terms economic growth has been pretty steady post-WWII.  A lot of that has to with the way modern central banks deal with recessions.  They take a very active role in smoothing out the business cycle.

As usual, the story gets much more interesting when we adjust for inflation (using today’s dollars as a base):

Now all sorts of shapes and patterns emerge!

It’s easier to see the inflationary effects that the massive increase in government spending had in the mid-40’s; in real terms, GDP contracted substantially.  It’s also easier to see the W-shaped recovery we saw in the early 80’s.  Today, you’ll notice that real GDP has stalled since about 2005, coinciding with the peak in the housing bubble.  In nominal terms, this current recession has been pretty nasty, but because of the deflation – as damaging a force as it is – the drop in Real GDP hasn’t been so bad.

But you can see that most of these bumps and stalls in the economy are due to inflationary/deflationary effects, not nominal economic growth or contraction.  The economy moves slowly.  The CPI can hop around.

Subjective filters

Like I mentioned above, people don’t typically make inflation-adjusting calculations on the fly when comparing past data to present.  But whether or not they realize it, they are making all sorts of little adjustments, incorporating price inflation, the economy, the job market, their expectations for the future, levels of taxation, their general sense of security and happiness, and their confidence in consumption.

The result is what they feel.

When people talk about these letters, they’re not really talking about what path GDP is going to take.  GDP moves way too slowly and trends too strongly in one direction.  In real terms it’s far too dependent on inflation, which is to a certain extent “managed” by The Fed and Treasury.

They’re describing what it’s going to feel like, which again underscores what I’ve been talking about for so long.  There’s a lot of data and a lot of noise floating around out there, but the human element to these markets and this economy matters much, much more than the talking heads in this industry give it credit for.

It’s why we use letters to describe it.  People have an innate understanding of visual shapes.  They don’t have an innate understanding of the calculus behind them.

This means something to people:

This doesn’t:

y(t) = A * sin(wt + θ)

Even though they’re the exact same thing.

The Hockey Stick

So, what’s this recession going to feel like?

None of you should be surprised: it’s going to feel like a great big hockey stick.  Things felt worse and worse and worse and then earlier this year things finally stopped feeling worse.  This summer they haven’t really gotten any better, and we don’t expect them to improve significantly from here.  Collectively, we’re happy that things have stabilized.  But nobody’s really dancing around, feeling progressively more optimistic on our economy, and brimming with the confidence they were several years ago.  We feel like we’ve hit the bottom and the longer we spend here, the more normal it will feel.

Even though all the nominal GDP recoveries have been V-shaped and nominal GDP will probably start rising again from here, I’m not convinced that people today will really be feeling all that V-power.  But like any good little scientist, I’ll keep my eyes open for evidence to the contrary.  If you all are gearing up to spend, spend, spend, by all means, let me hear at feedback@thedraconian.com.

Now, what investment implications will a Hockey Stick Economy have?

Of most relevance will be a stock market that goes up and down.  During the next several years stocks are going to go up and down.  Up and down.  This year stocks have gone up.  In a world where GDP growth is very modest and consumers are feeling flat, stocks will not go up forever.  That’s not a prediction that stocks will go down from here.  They may certainly continue to rise, but the higher the market goes, the more difficult it is to justify with the fundamentals of a Hockey Stick Economy.

Over the long run, it’s hard not to envision a scenario where the dollar gets progressively weaker.  I mean, nobody seriously thinks that the U.S. is going to work its way out from under all this debt.  We’ll tread water, servicing the debt with interest rates lower than the already-modest inflation rate.

Don’t forget, we still haven’t solved the mortgage crisis.  There is far too much stinky debt and not enough capital on our balance sheets to cover it – whether it’s the case of negative equity for homeowners or whether it’s banks with piles of under-performing, over-priced debt on their books.  The only way out of that scenario is a magical, rapid increase in asset values, or a realization and writing-down of losses which would likely send these firms into bankruptcy.

None of that seems likely, and so far the plan has been to just borrow and stimulate our way through as we buy time to sort out the mess.

On the subject of stimulus…

ZOMBIE BANKS FROM JAPAN!!!

The government’s response has been to pick up the slack in consumer spending by doing the spending itself.  This is a key principle in Keynesian macroeconomics – the government steps in to stimulate the economy to avoid or mitigate recessions in the business cycle.

There is no question that we’ve moved towards the Keynesian pole in the world of popular economics and the free-market folks from the Chicago school have been taking a lot of flack during this shift in economic philosophy.  It doesn’t seem so long ago that “totally free markets” were the answer to basically every economic question, but today Keynes is back with a vengeance.  To some of us this seems odd; Keynesianism had been on the outs for a long, long time.  When I was studying economics at UCLA, Keynes was in a lot of ways the economic corollary of Freud – a revolutionary thinker who singlehandedly shifted an entire academic paradigm, and whose ideas we now accept to be pretty much wrong.

But today he’s suddenly very right, and the reason why is because Keynesian economics offers essentially the only solution to recessions that doesn’t involve incredible short-term pain.  And the United States of America has no tolerance for short term pain.  Why should we when our democracy enables us to vote ourselves what we wish?  If our representatives in Washington D.C. don’t give us what we want – to feel better RIGHT NOW – then we simply vote them out of office and elect somebody else who will make it better RIGHT NOW.

The Keynesian framework is the only one that is remotely close to politically feasible and we’re still in the early innings of the greatest bull market in politics since the 1930’s.  The answer to the question “is Keynes here to stay?” is a resounding yes.  But the efficacy of this policy is a separate debate and will play out in the coming decade.

Champions of government stimulus, led by none other than Ben Bernanke himself, point to the Great Depression.  It took a long time, but government spending and intervention did bring us back.  The government ran huge deficits and its outstanding debt skyrocketed to facilitate the war and the public works programs.

But has everybody forgotten Japan?  After Japan’s stock market and housing market collapsed, the government response was straight from the pages of Keynes, from the real experience of the U.S. during the Great Depression.  They stimulated and stimulated some more, and the result was:

Ugly.

The Keynesian response didn’t work in Japan.

What also failed to work over there was their artificial “propping up” of the banking industry.  Their post-bubble crisis was also similar to ours in that it left most of their large banks with mountains of toxic assets and bad debt.  Japan kept their banks alive through bailouts and life support, banks who were, for all intents and purposes, dead.  You may be familiar with the term “zombie bank” in a Japanese context.  How long until we hear it in the U.S.?

I’ve mentioned before to just categorically avoid bank stocks as an investment.  Trade ‘em all you like if you know what you’re doing, otherwise just stay away.

This is why:

Those are the stocks of three of Japan’s largest banks, Nomura (blue), Daiwa Securities (brown), and Mizuho Bank (black).

Am I heretic for suggesting that Citigroup, Wells Fargo, and Bank of America might follow a similar path over the next decade or two?  Like their Japanese counterparts, these were companies that made bad, bad decisions and instead of being punished for it, they were artificially kept alive with government aid.  Yes, bank stocks went nowhere for over twenty years, but also notice how much they can move in a short period of time.  A gain of 100% in a single year is nothing for a zombie bank, nor is a loss of 75%.

You see now why I prefer categorically avoiding the financials?  Bank of America is up a few hundred percent off its lows in March.  I missed it.  Bummer.  But I have a reasonably good idea how the story will conclude.  That party could end at any moment.

I’m a square so I don’t mind staying home on Friday nights.  Others are welcome to have fun and risk the hangover on Saturday morning.  It’s like what I talked about last week.  Find investments that work for you.

It’s tricky making comparisons between Japan and the U.S. because we are so different in so many ways.  Japan has horrific demographics and a very different national psychology, neither of which are conducive for long-term economic growth.  But the U.S. of today is very different from the U.S. of the 1930s and 40s.  We’re no longer a manufacturing-centric economy, and since then our national psychology has also changed a great deal.  It’s tough to look at historical analogues to gauge whether Keynesian stimulus will work.

The lesson here is that our current policy response may not be the correct one.  But it’s the only one that’s feasible, so let’s cross our fingers, say a prayer, and hope it works.  In the meantime, get comfortable with the idea of gargantuan deficits and rising government debt.  And before you flee to your bunkers and cry that deficits will ruin our country, keep in mind that Japan – the second largest economy in the world – has been cruising with a huge debt-to-GDP ratio (currently 170%) for a long while.  That hasn’t ruined their country:

Mediocrity is certainly an option for us too.

September 22, 2009

First, a quick thanks for all the comments on the housing piece.  I combined the three parts into one epic megapost.  I also moved our site to a new web server over the weekend which should give us more flexibility and room to grow.  You’ll notice a new ShareThis button above, as well as a convenient “printer-friendly” view if that’s your thing.

Market Recap

OK, let’s just cut straight to the elephant in the room.  The market has gone up 60% from its lows.  Sixty percent.

Everybody right now is asking two questions, the first of which is why?

Aside from things generally looking better than they did in the black abyss of March, there are a few other factors at work, one of which is simple mean reversion.  When any market moves too far one direction, it typically starts moving back to a more normal mean.  March was pretty far down there, and so naturally, one should expect a snap back to more average levels.  But it’s only easy to see this in hindsight.

Another possible explanation and contributing factor is a new round of dollar weakness.  Check out this chart of the US Dollar Index, which tracks the value of the dollar against a basket of other currencies.  It looks a lot like the inverse of the above chart, doesn’t it?

In a global economy, when the dollar goes down in value it usually means that the price of stuff denominated in dollars goes up.  That might sound a little strange, so consider this example.  Imagine for a moment that you’re a middle eastern oil producer.  Pretty awesome gig, I know.  At least for now.  Crude oil is priced in U.S. Dollars, and if the value of the U.S. Dollar falls 10% relative to your currency, your solution is to simply ask for 10% more dollars in return to make up for it.

The U.S. stock market is denominated in dollars too, and to a certain extent the same relationship applies.  The rally since March has been pretty darn impressive, but it’s been magnified by a dollar that’s collapsing in value relative to other currencies.  Why is the dollar falling?  Simple.  The government has been printing them like mad men to ward off deflation.

Stock and commodity prices usually go down during periods of increased risk, but be warned that a sharply strengthening dollar can magnify that effect as investors around the world buy dollars as a safe haven.

The second question everybody is asking right now is where does it go from here?

I wish I knew.

Where the answers may lie

One of the Big Ideas in the still-young field of Behavioral Economics is the concept of loss aversion.  In the traditional world of economic theory, the material that’s been taught in universities around the world for a century, individuals are assumed to be rational.  Everybody – even economists – understands that this couldn’t be further than the truth.  People are not rational.  They are emotional and crazy, and they do crazy, emotional things.

The concept of loss-aversion simply states that people are more strongly motivated to protect what they have than risk acquiring potential gains.  In other words, people are generally more fearful than they are greedy.  Believe it or not, this simple principle had never been accounted for in any branch of classical economic theory.

It might sound pretty intuitive to you, someone who lives in the Real World.  But to economists, who live in the magical land of Econotopia, this was pretty revolutionary stuff.  Check out the recent laureates for the Nobel Prize in Economics.  A lot of them won for doing work on the new frontier of behavioral economics.  Back in the day at UCLA I couldn’t take any classes on this.  Nobody was taught any behavioral economics, we all just politely accepted and swept under the rug the disturbing notion that our entire field of study was dependent on the erroneous assumption that individuals were rational.

Apparently, that bothered others a lot less than it bothered me.  I had to travel by myself to the outer fringe of Econotopia to find material to help me resolve this problem.  It was there I discovered Richard Thaler, along with the groundbreaking duo, Kahneman and Tversky.  Back in the 90’s these guys only had a cult following, but today they’re suddenly very fashionable!  Thaler has a new book out, Nudge: Improving Decisions About Health, Wealth, and Happiness.  Check it out.  It’s fun for curious minds of all ages.

Stuff like this really gets me excited – it’s pioneering economic theory for the masses, and Thaler has the rare gift of making it interesting without compromising its theoretical merit.  Dan Ariely is another one doing legitimate, accessible work in this developing field.  He was a frequent guest on CNBC last fall and his voice was a very fascinating, unique one amidst all the the chaos.  I wholeheartedly recommend his book Predictably Irrational to econ wonks and regular folks alike.

To bring the discussion back to the markets and where they might be going, keep in mind that last year loss aversion dominated market psychology.  When everybody thinks this way at once it leads to spiraling losses as investors sell risky assets and lower and lower prices.

Today, a different form of loss aversion is showing up.  Fund managers and investors are terrified of losing out by not participating in the market rally.  You might argue that’s actually greed, not loss aversion.  But you’re not thinking like a mutual fund manager.  If a fund manager’s mutual fund doesn’t go up or fails to beat the market, he typically loses assets because the cost of switching funds is very low for investors; they simply sell his fund and go buy another fund that did go up.  Given how mutual fund managers are compensated, losing assets translates directly into losing revenue.

You can see now why it’s so difficult for mutual funds to sit idle while the market roars upward.  I can tell you for a fact that most mutual fund managers are not psychologically equipped to handle this.  If the market is going up and their fund isn’t, panic sets in.  At some point, they buy out of fear, chasing market performance, hoping it will help them beat their benchmark lest investors leave them if they don’t.

It’s always difficult to determine to what extent things like this can move the market.  But psychological factors like this can extend trends for far longer than most people think possible.  In fact, that’s the first rule of super trends: they always travel much farther than anybody ever thinks possible.

As I’ve said before, I think this market can keep right on running upwards for these bizarre reasons.  I just won’t be a part of it.  I see better opportunities that carry less risk elsewhere.

Hopping towards performance

After 25 years of investment management and working much more directly and actively with our investors than most funds, we can speak with a modicum of authority on investor psychology.

Investors, by and large, are a fussy bunch.  They want to make money all of the time.  And the two things that are most annoying to them are 1) losing money and 2) not making enough money when the market is going up.  In essence, they want to always be making more money than the market and never losing it, which is certainly an admirable thing to want.  However, what differentiates the successful investors from the poor is the degree to which they can reconcile those wants with reality.

There are no investments, no portfolios that go up all the time.  Or at least none that are easily accessible or return more than the risk-free rate.  There are no traditional investments that always beat the benchmark over every single window.  Every investment goes through periods of underperformance and outperformance relative to its benchmark.

Most investors just hop from lily pad to lily pad in search of higher returns and when there are scary waves in the pond, they react by attempting to jump out altogether.  Never mind the fact that the appearance of one series of waves doesn’t necessarily mean that a second series is to follow or that a pond that has been calm for a while means that it’s safe to hang out too far away from shore.  They hop and hop, hungrily chasing profits, until the rare moments when suddenly fear of loss trumps everything.

With a market like this, you need to figure out what’s important to you and ask yourself some tough questions.

I feel like I’ve asked more questions than I’ve answered in these newsletters.  I don’t feel bad about it, though.  I firmly believe that the true path to investing success starts with a deep understanding of oneself, and that’s only possible through self-inquiry and self-examination.  So few investors understand themselves well enough to make investment choices that are right for them.

Consider:

• Can you sit on the sidelines while the market goes up and up?
• Ignoring the past completely, how big a loss are you willing to tolerate today?  Do you think the gains from this point are worth the risk?
• Are you able to make peace with the fact that you haven’t participated in the rally since March?  If you have participated, are you able to prevent that excitement from affecting your present and future decisions?
• Will you be happier just knowing that you are in the market regardless of its direction from here?
• What do you believe the future will look like?

These are hard questions.  Trust me, it’s a lot easier to simply accept and follow the recommendations of others.  The problem with that is that these recommendations may be totally wrong for you and lead to irrational, reactionary decision making at some point down the road.  You’re also just following the crowd and could wind up on a lily pad with a few too many other frogs.  That’s seldom good for the lily pad or the frogs on it.

Me & You

Today, I might think that TIPS are the bees knees, but if you’re a person who derives satisfaction from movement and activity, TIPS and their boring, mild return stream are going to drive you bananas.  I might think that global growth in coming decades will be driven by China and recommend things like copper producers or oil refiners for the long haul, but if you just don’t buy into China’s ascendance, then don’t own things that are predicated on that transpiring.  I might think that stocks are generally risky and expensive at this point, valuations which are not justified by what I think will be a disappointing stream of future cash flows.  But if you simply can’t sit still while others are partying on as the market goes up, for heaven’s sake, why haven’t you accepted the risks and loaded up on stocks!?!

Look, I ask a lot of questions because I don’t have all the answers.  I have managed to accumulate a few answers here and there, but they’re my answers.  Some of them will solve your problems, but some of them will just create more.

Unfortunately, you need to be the arbiter of what works for you and what doesn’t.  This is an existential reality that you must come to terms with as an investor, and it’s tiring work.  Sorry.  That’s life.  If you want the easy answers, just go follow Jim Cramer, but don’t come crying back here when his picks don’t pan out.

Our goal is to make this newsletter one that is both interesting and useful.  Being interesting is a vague, ethereal art.  It’s much easier to be useful and we do it by trying to help you be a better fisherman rather than simply catching fish for you.

I like to eat fish as much (actually, more) than the next guy, but as a novice fly fisherman I’ve found much more value in the lessons that taught me how.  Lord knows there are plenty of voices out there that tell you exactly which flies to use and which holes to fish.  Your mileage may have varied, but my honest experience with those voices has been pretty mixed.  The best – by far – were the ones that taught me how to be a better fly fisherman, the voices that simply helped me enjoy the art of fly fishing more.

And would you believe that was what helped me catch more fish?

An industry pauses to reflect

Last week was the one year anniversary of Lehman’s collapse and the spectacularly massive bailout of insurance-firm-turned-casino, AIG.  This month the industry has been uncharacteristically introspective, which for a highly introspective fellow like myself, feels very much like home.  If only the industry felt this way all the time.

There were a lot of theories about why Lehman went down and why the government didn’t (couldn’t) do more to save it.  Lehman’s failure was a seminal event in the history of finance, and it was frequently pointed to as one of the reasons why the markets went into freefall.

One thing that needs to be understood is that Lehman wasn’t the cause, it was a symptom.  The disease was fear and a lack of credit-worthiness and that manifested itself in Lehman’s case as a good old fashioned run on the bank.  All of a sudden, nobody wanted to lend money to anybody because they were terrified of not getting paid back.  The world of modern finance simply doesn’t function when nobody wants to lend money.

Consider this delicious exchange from 1992’s way-ahead-of-its-time hacker classic, Sneakers¹.  Robert Redford plays the security consultant hero, Martin Bishop, and Ben Kingsley plays the villainous technology titan, Cosmo.

Cosmo:  Posit – people think a bank might be financially shaky.
Martin Bishop:  Consequence – people start to withdraw their money.
Cosmo:  Result – pretty soon it is financially shaky.
Martin Bishop:  Conclusion – you can make banks fail.
Cosmo:  Bzzt.  I’ve already done that.  Maybe you’ve heard about a few?  Think bigger.
Martin Bishop:  Stock market?
Cosmo:  Yes.
Martin Bishop:  Currency market?
Cosmo:  Yes.
Martin Bishop:  Commodities market?
Cosmo:  Yes.
Martin Bishop:  Small countries?

…

Cosmo:  There’s a war out there, old friend.  A world war.  And it’s not about who’s got the most bullets.  It’s about who controls the information.  What we see and hear, how we work, what we think… it’s all about the information!

This was what killed Lehman Brothers.  It was what killed Bear Stearns.  It wasn’t a war, per se, but it did ultimately wind up being all about information and perception.

Yes, these firms had legitimate problems.  But during periods overrun with fear and panic, information flow gets a little fuzzy.  These firms were technically fine until concerns developed about their solvency and their ability to pay back their creditors.  Naturally that sparked a run in their prime brokerages – every hedge fund I knew at the time was pulling their accounts with Lehman as quickly as they could.  With a diminished capital base, these banks now actually were insolvent.

Now: given that the problem was information flow and image, what would make for a logical solution?

Make them look better.

I think at the time, we all had a sense that, as bad as things seemed, things weren’t really as bad as they seemed.  The government’s natural response was to get George Bush and Hank Paulson up there to simply tell us that everything was going to be fine.  That didn’t work for a variety of reasons from an exhaustion of credibility to a lack of understanding of the problem.  But soon the banks and the government did figure it out.

Step one was the stress-tests.  These were ridiculed at the time, by myself, other hedge fund managers, and other economists and academics.  The tests were kind of ridiculous, with odd, arbitrary assumptions and subject to big-time self-reporting bias.  It turned out that none of that mattered.  The market bought into the conclusion that these banks would be fine.  Suddenly these were solvent, sound financial institutions again.

The FDIC guaranteed all deposits up to $250,000 – never mind the practical impossibilities of that.  It was the perception of a sovereign safety net that truly calmed people down.  It didn’t matter that the net wouldn’t support everyone if they fell.  For the third time in a century, economists dusted off their Keynes and saw that, yes, it was indeed theoretically possible for the government to step in and guide us all through.

Look around.  Epic stimulus programs.  Are these really a good idea?  Economically, maybe not.  But if they make people feel better about things, then they probably are.  Look at banks paying back TARP.  Financially, this is a terrible idea.  They got that money at great terms with little questions asked – why give it back?  What matters was the message these banks would send by paying back TARP, that they were strong enough not to need it.  To restore confidence.  Not every bank has indicated a desire to pay back TARP, but those that haven’t, like Bank of America, have boasted about their success at raising capital.

As I reflect this month on the events of the last year, this is what sticks with me.  Our fears were significant, but I think we’ve all learned that we have a government that’s big enough to mitigate them if it wants to.  The perception of a sovereign safety net will have major consequences, both intended and unintended.  And with that net in place, I think it’s naive to assume that it won’t be tested again and again.

Whether or not it actually holds up is anybody’s guess.

—

Feedback@TheDraconian.com
Subscribe to the Newsletter by Email
Read the Legal Disclaimer

—

¹Seriously, this should go down in history as one of the best casting ensembles of all time, or certainly for anything not directed by Robert Altman:  Redford and Kingsley, Dan Aykroyd at his best, Sidney Poitier, Mary McDonnell, the criminally underappreciated David Strathairn, River Phoenix in one of his last performances, an early Donal Logue, Timothy Busfield, character-actor wizard Stephen Tobolowsky, and a even James Earl Jones in a scene-stealing bit part.

September 19, 2009

Today we’ll embark on a little journey through the current housing market.  There’s been a lot of hubbub in this sector lately and at long last (phew!) some legitimately good news seems to be emerging.  As usual, the story is both more complicated and simplistic than it seems at first blush.  In this piece we’ll cut through a lot of the noise and bring into focus a few things that really matter.

Is the crash is over?

The term “crash” in the housing market takes on a slightly different meaning.  Suddenness is the key dynamic in crashes of any sort, and in real estate nothing happens suddenly.  The housing market has been “crashing” for two years now.

Recently we’ve had slight increases in existing sales, a slight increase in the Case/Shiller Home Price Index, and a slight increase in median sale prices.  Prices and home sales typically rise during the summer months so a lot of this is seasonal and a lot has to do with a decline in distressed sales.  Let’s everybody hold their horses until we move through winter.

But the good news is that the crash is probably over, not because of these flimsy data points, but because valuations are finally entering a range that makes some sort of sense.  I’m certainly not saying that real estate can’t go lower from here (in fact, in a minute I’ll show you that it can), just that there is finally some light in the tunnel in the form of price stabilization and I don’t think that the next 12 months will look like the last 24.  Those of you buying a house today are not going to get burned the way people who bought houses in 2005 and 2006 did.

The bad news is that there isn’t going to be a recovery in the sense you might be expecting.  Those of you buying a house today are not going to be rewarded the way people who bought houses in 2000 and 2001 were.

Have a look at this:

Well, does it?  Does that chart make you excited?

That’s a 20-year chart of real housing prices before the bubble.

Guess what.  Now that the finance-bubble has popped and real estate has fallen to more-sane-but-not-cheap valuations, it’s a good bet that the next 20 years of housing prices will look very similar.  Yawn.

I don’t mean to sound flippant, I’m simply trying to illustrate that the days of our obsession with home prices are quickly coming to an end.  Ten years from now nobody is going to be nearly as concerned as they once were with whether their house went up or down in value over the previous 12 months.  This will be the indirect result of the stabilization.

During the dot-com fallout we needed something to cling to, an “investment life raft” that was reliable and easy to understand, something that would soothe our psychological anxiety as the stock market was crumbling around us.  The result was a wave of personal finance literature about how one’s home was actually one’s biggest and most important investment.  The artificially-low interest rate environment simply added fuel to the fire, as did cherry-picked data that gave people the impression that home prices never went down.  Those nasty little seeds would later give birth to perhaps the greatest bubble in history.

Your home is not an investment in the typical sense.  It’s a mechanism for forced savings and always has been for most of the entire history of real estate prior to the early 00’s.

During the bubble we forgot all about that and it empowered us to do ridiculous things.  Maybe we traded up and transferred all that savings to a bigger house with a bigger mortgage.  Maybe we tapped some of that savings with a HELOC and used that money on… a new boat.  It was an investment that always went up!

But prices started going down and wiped out all the rest of the savings we’d accumulated whether by 30 years of steady payments or the rapid increase in price during the bubble.  I realize that has been rehashed elsewhere ad nauseum, but it brings me to my next point which hasn’t quite been getting the attention it deserves.

Negative equity is a serious, serious problem right now

Just because the crash is over doesn’t mean real estate’s woes are in the rear view mirror.  Far from it.  In fact, we’re now just getting to the really tricky part.

It’s estimated that right now around 15 million homes are worth less than the mortgages on the properties.  That’s about a third of all mortgaged homes.  Yikes! Here in Nevada, about 66% of homes are estimated to be in a negative equity situation.  Sure, much of that is Las Vegas’ problem, but up here in Reno it’s still a legitimate issue.  Deutsche Bank recently estimated that the number of homeowners with negative equity could approach almost 50% by 2011.  Double yikes!

This is a massive, massive problem for the banks and entities that hold the other side of these mortgages.  Who knows how they’re accounting for them on their balance sheets.  Who knows what that’ll do to their earnings, the financial system, and the market/economy at large if and when they start writing more of that stuff down.  Banks are very clever.  All that bad debt isn’t any better today.  Some of it may have changed hands, but it hasn’t gone away.  Bad debt doesn’t just disappear; somebody pays.

On the individual level, negative equity is a big problem because it makes people feel poor.  Not enough people in this industry gave the wealth effect our nation felt during the housing boom enough credit for the way it drove consumer spending and thereby fueled GDP.

This was a favorite chart of mine from a few years back:

Not exactly a shining endorsement of the U.S. economy in the early 21st century.  Things have been much worse over the last decade than we may have realized.  Public policy and the financial environment has basically amounted to “giving the kid more candy to keep him from getting cranky.”  Parents know that usually ends with tears all around.  But this is how we like to solve problems in the U.S.  We are a nation hypersensitive to short-term pain and democracy gives us the power to vote ourselves what we wish whether it’s in our long-term interests or not.

To the matter at hand: it’s not too simplistic to say that nearly all the economic growth we enjoyed post-2001 was due to home equity credit extraction.  All this is very consistent with Friedman’s permanent income hypothesis which I’ll break down for you as follows:

1. We expected our homes to keep rising in value.
2. We felt more wealthy.
3. We spent more as a result.

Now, reverse that within the framework of a falling or even flattening real estate market, and it adds up to a consumer that’s much less comfortable spending money.

As the son of an arch-conservative, fiscally-hawkish commodities trader I suppose it was impossible for me to ever grow up into a man that wasn’t compulsively obsessed with the concept of value.  I would never have called myself a big spender to begin with, but after the last year, even I am noticeably more careful with how I spend my money.  I’d wager that – regardless of your situation and where you’ve come from – today you probably feel the same way.

Tell me that’s not a huge drag on economic growth.

How do we solve the problem?

If you think about it logically there are really only two solutions to the negative-equity problem.

• OPTION A: Housing prices re-inflate substantially (think 50-100%), which is flat out ridiculous.
• OPTION B: The value of these mortgages need to be marked down and the lien holders i.e the banks eat the loss.  It’s equally ridiculous to do this all at once given the chaos of last fall.

There have been a variety of proposals in between those scenarios that have been suggested, and the path that we seem to be travelling seems to be closer to Option B since that’s the only one that is at least somewhat realistic and the only one that anybody has any sort of control over.

During the crisis of 2008, the decline in value of housing relative to the debt against it and the myriad derivative contracts stemming from this problem made many, many financial firms technically insolvent.  That was when Captain America flew to the rescue and controversially used public funds to recapitalize (“bail out” if you prefer) these insolvent firms.  Step two was to create an environment where banks could be extremely profitable and then use those profits to slowly offset the losses associated with all this stinky debt.  When these banks started making tons of money in Q1 and Q2 this year, this too was controversial.

Eventually, all that debt will be worked off and replaced with better debt.  That’s how banks handled the last debt crisis, and it’s how they’ll handle this one.  But it’s like dieting.  Losing weight takes time and dedication, and it isn’t much fun.  I recognize that we are a nation obsessed with quick fixes, but it’s impossible to clean this mess up overnight.

We all may stop caring so much about home prices, but the state of this market will have major economic implications for a long time.  Hence, the “New Normal” that I’ve been discussing here for months now, and that’s also been discussed (in far more elegant, effective language) elsewhere.  Life is no longer easy for investors.

A nose for real estate

I have a 3 year old Westie named Bishop.  As a fellow schedule-oriented creature, he looks forward very much to our afternoon walks every day from 3-4pm after I get home from work.  Our neighborhood is typical tract housing.  It’s a nice neighborhood in one of the nicer parts of town, but it’s modern tract housing nonetheless.

During the first year of our walks around the neighborhood it seemed like just about every house was for sale – no joke, 5 or 6 for sale on a street of a dozen homes.  This, of course, was 2006, right near the peak.  Something wasn’t right and I’d guess that at that point even my new puppy had a better idea of where real estate was headed than a lot of the crazies that were trying to flip this and that.

By mid-2007, the “For Sale” signs slowly started to disappear, but that’s when the real problems were beginning.  Stocks (always a leading indicator) started going down and margin desks around the world started calling in leverage.  Construction on the new development to our east stopped immediately.  Bishop didn’t mind, never really a fan of the noisy dump trucks and bulldozers.  But no more dump trucks would mean no more people getting paid to drive them.  What consequences would this have?  Neither of us were exactly sure.

By mid-2008, the neighborhood was dotted with one or two dead lawns per cul-de-sac.  Weeds had overtaken other properties.  Most of these houses were built between 2003 and 2006 and by 2008 had been nearly halved in value.  I bet Bishop a bag of Pup-Peroni that well over half of all the mortgaged houses here were under water.  He just cocked his head and looked at me funny.

Today when we walk around the neighborhood, things feel a little better.  There is what seems like a normal number of houses for sale.  But there are still empties here and there, and still a few weed-infested, dead lawns.  Some of you may have had experiences like this, but it’s likely that this is still a regional phenomenon.  Until these vacant or distressed houses sell – not all of which are technically listed for sale, mind you – the housing market will not have found its bottom.  There’s still simply too much supply on the market and counting on an increase in demand to clear this condition is a shaky proposition.  I doubt even Bishop would take that bet.

The point, though, is that these houses aren’t appreciating in value.  They were built in the middle of the boom and bought with little money down.  Virtually every house that sells in my neighborhood today does so at a price less than the mortgage associated with it.  Somebody eats that loss, and no accounting legerdemain can make that write-off disappear from a bank’s financial statements.  Unless, of course, the bank in question is Goldman Sachs.

How much house can I afford?

Now, a simple exercise to illustrate the concept at the  heart of some new analysis.

STEP 1: What is your total annual household income?
STEP 2: If you had to buy a new house tomorrow, how much house would or could you buy?  A $250,000 house?  A $1.0 million house?
STEP 3: Divide that price by your annual income.

This is your price/income ratio.  It’s probably somewhere around 3:1, right?

This exercise obviously won’t apply if you’re retired or are in a similar situation where you now have a lot of assets but not necessarily a lot of income.  It also breaks down at the high end of the curve; if you’re in the market for a $5 million home, you probably aren’t earning $1.7 million per year.  Maybe you are.  I don’t know.  If so, you clearly don’t need to listen to little old me!  So just imagine that you’re somewhere in the middle of your career – just enough liquid cash for a 20% down payment and enough income to cover the mortgage and the rest of the monthly bills.

The neat thing about this calculation is that we can do it for the nation at large.  At the end of the second quarter 2009, the median annual household income in the U.S. was $60,671 and the median existing home sale price was $181,711.  This was a ratio of almost exactly 3:1.  In aggregate and on average, people in the United States were buying homes that cost around three times their annual household income.

Over the long run, this is a ratio that stays somewhat constant.  There’s good reason for it, too.  Lenders typically won’t lend to you if they know you don’t have enough income to meet your monthly mortgage payments and homebuyers will typically buy as much house as they can afford.  These two forces make for a rather natural equilibrium.

Most of the chatter one hears in the housing market centers on home prices, prices, prices, whether it’s existing home sale prices or the Case/Shiller price index.  Every so often we hear about mortgage rates or the number of homes sold.  But one thing that’s seldom discussed when it comes to housing is incomes.  The level of one’s income – both current and expected – is a very important factor when it comes how much an individual will spend on a house.  It’s probably the most important thing, so long we live in a world where banks require down payments and don’t lend money for free.

This is one of my favorite charts that I maintain one I wish I had in front of me back in 2005:

The recent jump in both price and price/income ratio is purely seasonal.  We saw it last summer, the summer before, and we’ve seen it in pretty much every summer before that.  The only reason that doesn’t appear on on this graph is because that data set is published annually before 2007 and so I had to smooth it to a monthly trend.  (If anybody knows any good data sets for housing prices, please let me know!)

Looking at this chart makes a few things very clear:

First, home prices at the peak were flat-out insane and though we may all have felt that things were kind of expensive at that time, we really, really had no idea just how ridiculously overvalued residential real estate was by every metric imaginable.

Second, home prices right now in real terms still might be considered moderately overvalued.  In other words, the blue line has room to go down.  Over the long run the chief driver of home prices is inflation, so when you factor inflation out, prices are fairly stable.  They only really go up when aggregate wealth and incomes are increasing in real terms, or the environment is changing in a way that makes it easier to pay more money for a house.  Things like the popularization of the 30-yr mortgage, the tax incentives of mortgage interest, and the expansion of lending to those who previously had no access to credit i.e. subprime lending.  All these environmental changes allowed people to pay more money in real terms for a house.

Taking away those things would add downward pressure to home prices.  Can you imagine what requiring people to pay cash for a home would do to prices?  What if Congress changed the tax code so that nobody could deduct mortgage interest on their tax returns?  The last decade was an eventful one.  Very quickly it became very easy to pay a lot of money for a house and then even more quickly, all those things that made it so easy to pay a lot of money for a house were taken away.

The price/income ratio is much more reasonable today than it once was, though it’s still about 5-10% above the long-term (ex-bubble) average and nowhere near historic lows or the lows we saw in the 1991 recession.  Factor out the steroidal effects of the credit bubble and homes are still more expensive relative to incomes than they have been in 25 years.  Kind of a scary thought, no?

You’ll notice a jump in the price/income ratio in the early 80’s, but that wasn’t because real house prices went up (they actually went down!) but because incomes fell by so much during that nasty recession.

Incomes haven’t fallen so much during this recession but it’s interesting to note that they have been flat-lining for the last decade.  I know you didn’t need another reason to convince you that everything since the dot-com bubble has been financially-engineered smoke and mirrors, but there it is.

Given the massive hurdles our economy now faces and a historic scaling-down of the labor market that will likely continue for a while, do you really think incomes are primed to rise?

With banks failing all around and others curbing their lending dramatically to reduce risk, does anybody out there think that credit will magically become easier to obtain?  Think the 2%-teaser 0%-down mortgage will make a comeback?

Because of the collapse in the stock market and real estate market, American household balance sheets aren’t looking too great.  Households are still overleveraged, too heavy on the liability side and stuck with assets that are worth a whole lot less.  Net worth is way down which means less money for a down payment which means less people buying houses which means lower prices.  That doesn’t even begin to address the psychological effects that reduced net worth also brings.

I have a very hard time believing that home prices will “recover” here, much less even begin to trend back upward.

Should I buy a house?

Sorry folks, but there still could be another 10-15% downside in home prices.

I know.  That sounds crazy.  Another 10-15%?  It’s clearly possible from a technical analysis perspective.

When you realize the bubble in that chart (which was deceptively slow to form) was completely bogus and based on easy finance and lax lending standards, and add on top of that all the current fundamental problems with real estate right now like massive excess supply, and add on top of that the economic headwinds our nation will be up against over the next decade, another 10-15% drop starts to sound more reasonable.

A drop like that isn’t quite so scary on its own, but given the complete lack of upside in housing it should give you nightmares as an investor.  I try and read as much material as I can from as many different viewpoints, but I’ve yet to come across any reasonable arguments for significant appreciation in home prices.  Call me a Negative Nancy, but I think stabilizing prices are a best case scenario for this market.

That being said, if:

1. You need a place to live.
2. Plan on living there for a long time.
3. Have good credit and can easily afford the monthly mortgage payments.

you have my blessing to venture forth and buy a house.

The Homebuyer Tax Credit

Speaking of buying a house, check this out:

NAR estimates that about 1.8 to 2.0 million first-time buyers will take advantage of the $8,000 tax credit this year, with approximately 350,000 additional sales that would not have taken place without the credit.

OK, current and future taxpayers, that’s about $16 billion you just spent to spur home sales.  That’s roughly $45,700 per additional house sold.  Hope it was worth it!

Before the bubble, back in the 90’s, existing home sales would run around 4 million per year.  As the bubble was inflating, sales would run about 5 million per year.  During the peak, existing home sales topped out at over 7 million per year!  In 2009, sales have averaged at about a 4.7 million annual rate.

Incentive programs like the homebuyer credit typically have the effect of pilfering future demand and transferring it to the present.  That’s not always a bad thing.  But people don’t buy houses the way they buy milk.  Inventory turnover in the housing market is very, very low relative to other goods.  Does this mean that home sales in 2010 will clock in 350,000 units below 2009, so long as everything else stays constant?  Not quite, but within that 350,000 additional homes that were sold is a certain number of people who were on the fence and looking to buy a house at some point in the future.  Those folks did it this year and won’t next.

I mentioned above that environmental changes that enable individuals to spend more money on a house can positively impact prices.  It’s difficult to measure, but the Homebuyer Tax Credit has unquestionably had a positive effect on prices.  How could it not?  With the current median existing home sale price where it is, that credit amounts to a 4-5% discount!  Keep in mind, however, that this is not a permanent shift in the environment.  Any positive effect this has had on prices will be short lived.

More broadly speaking, it’s disturbing that individuals seem so reluctant to spend unless they’re given a freebie in the form of a government incentive like this homebuyer credit or cash-for-clunkers, or a midnight sale.  That’s very deflationary when it comes to prices, and I wouldn’t bet on retailers regaining significant pricing power any time soon.  Assume for the sake of argument that the U.S. consumer is in dramatically better shape to begin calendar year 2011.  Will he have forgotten the trauma of ’07-09?  Will he be willing to pay full price for the goods he so recently was purchasing at significant discounts?  Tough to say for sure.

At least it’s stimulating…sort of

Any way you slice it, that’s still about $16 billion of stimulus.  $16 billion is a lot of money, but it doesn’t really move the needle of a $14 trillion economy.  Families will get that $8,000 back after filing this year’s taxes and then what will they do with it?  The last time Captain America handed out free money, in early 2008, people wound up saving most of it or paying down debt.  Maybe this time they’ll spend it.

Either way, the effect is temporary.  Policies like this don’t make the economy any stronger over the long run, they won’t create new jobs, they won’t keep putting money in people’s pockets, and they won’t keep home prices from going to where they ultimately need to go.

Whether the stimulus was the right thing or wrong thing to do is best left for another debate in another forum.  My generation has the rest of our lives to figure this out and come to a conclusion whether all the costs were worth it.  None of that is going to get answered today.

To bring the discussion back to housing and summarize: the credit is unquestionably positive for prices over the short run and unquestionably negative for prices beyond that, but in the grand scheme of things it probably won’t matter all that much.

It’s like eating a Snickers bar.  It tastes great and gives you energy for the next hour or so but then comes the crash and the extra fat your body now has to deal with.  Tomorrow we will have forgotten about everything aside from what it cost us.

The Pig in the Python

I hate snakes, but this story creeps me out even more:

Certainly you’ve seen or heard of houses in your neighborhood that are sitting empty, where the previous owner, unable to make the monthly payments or unwilling to deal with all the negative equity, had simply walked out and left the keys on the kitchen counter.  You might also have heard stories about people who have stopped making their monthly payments yet continue to live in the house.   From what I gather anecdotally and economically, this is frighteningly common.

A couple months ago a colleague of mine was at a local event and he ran into a guy who was in a negative equity situation (this is Reno, after all), and he hadn’t made any mortgage payments in well over a year.  Instead of completely walking away, he moved in with his parents and – get this – started renting out his other house!  Not only was he not paying his mortgage, he was collecting pure income on the property!

Yes, that’s disturbing behavior, and probably illegal.  But what’s almost equally disturbing is that the bank had done nothing about it.  Things are really hazy in the world of banking right now, but how bad must things be where a mortgage can go 540 days past due and the bank not bother to take any action whatsoever to evict the resident or at the very least, make sure they aren’t renting it out on the bank’s dime!

I think it could have something to do with capitalization.  When a bank forecloses on a house, it’s forced to mark that house to market, a value that is almost certainly lower than the existing value on its books.  Write-downs like that en masse are disastrous for bank balance sheets, and with these entities on such shaky footing with such a delicate capitalization, I suppose it shouldn’t surprise me that they have been dragging their feet to resolve these problems.  The last thing on earth these banks need is more widespread fear that they’re insolvent.  That was a root cause of the mess a year ago.

Right now, this is the proverbial “pig in the python”.  There’s a whole lot of fat and toxic waste on these bank balance sheets – some more than others – and it’s just going to take some time for that all to get digested and pass on through.  It won’t happen overnight.  Some of it will be nutritious, but, to extend the metaphor, this was a pig that was mostly poison.

More Pigs in the Python

And now for my next scary story, which some of you may have heard before.  Below is a chart that was popular in certain concerned circles a year ago.  It’s fairly self-explanatory.

That’s some heavy-duty rate-resetting taking place next year and the year after that.

Subprime is behind us.  These were the loans put on during the bubble with ridiculously accessible terms for the first 1 or 2 years that would then convert to more conventional mortgages, the terms of which, would never in a hundred years make sense for those borrowing the money.  Not that the bank that wrote the loan cared, as it had already been packaged and sold downriver, somebody else’s problem.   But we’ve all heard enough of that.

From the chart, you can see that the next pigs in the python are Alt-A and Option ARMs.  These are borrowers that aren’t technically subprime, but certainly aren’t quite prime, either.  The economy has…changed a little bit since these loans were put on the books in the middle of the decade.  Today’s Alt-A borrower might look a little more like yesterday’s subprime borrower than a lot of banks may want to admit.

Option ARMs are the “Pick a Pay” loans you may have heard of where the borrower can choose interest only, interest + principal, or a minimum payment like your credit card.  They are primarily good credit score borrowers but the loans are mostly no-doc loans.  A majority have negative amortization schedules or high loan-to-values.  These are messy products.

There hasn’t been a lot of talk about rate resets this year because you can see that in 2009, relatively little is happening on this front.  That will change next year and 2011.  “Alt-A” and “Option ARM” aren’t quite buzzwords yet, but by this time next year they’ll be a part of everyone’s vernacular, though not to the extent that “subprime” was.  There’s no question “subprime” has a subtly-malicious je ne sais quoi that “Alt-A” lacks.

Realtors: Not Optimistic

According to an eye-opening survey of real estate agents on home purchases and mortgage activity in the second quarter, short sales that require bank approval are taking an average of about 10 weeks right now.

There are countless other interesting tidbits in the 165-page report, but let me do the work for you and highlight the interesting ones.  My comments are in brackets:

• “Down payment for mortgage” is the #1 impediment to first-time homebuyers seeking to buy a home.  [This is not good for long-term housing strength.]
• The market for home purchases can be divided into segments of 26% for damaged REO, 23% for move-in read REO, 14% for short sales, and 36% for non-distressed properties.  [Whoah. Nellie.  2/3s of all sales in 2Q09 classified as distressed!?  Is this real demand for housing or just another facet of the public simply demonstrating an unwillingness to consumer unless they’re getting a “deal.”]
• 43% of homebuyers are first-time homebuyers.  [From the homebuyer credit.  As discussed, this is a temporary increase in demand.

Qualitative conclusions (with statistical support):

• Non-distressed property sells slowly at small discounts, most often to first time homebuyers and current homeowners; few investors buy non-distressed property.
• Short sales, while significantly discounted, sell slowly, most often to first-time homebuyers.
• Few current homeowners list their property for sale and/or buy another property except for relocation or under duress.  [Somewhat disturbing that people are only buying/selling when they are forced to.  Bad news for the aspirational upper end of the market.]
• The upper end of the housing market consists mostly of non-distressed properties that are initially listed at premium prices, but must be discounted to sell after lingering on the market.  [Sound familiar?]
• Issues related to increasing mortgage rates are expected to grow in importance.
• Real estate agents view homebuyer tax credits as important in increasing home sale transactions and stabilizing prices, but in general, they favor time-based solutions to stabilize the housing market over financial incentives.

The results of this survey jive really well with what we’ve been talking about for the last few weeks.  This is good data, too.  Campbell Communications is in the business of conducting surveys, and there’s reason to take this information seriously.  It’s reliable information straight from folks on the ground level.

And speaking of realtors…

The National Association of Realtors says you should buy a house

Not that you need more reasons to be skeptical, but does anybody remember these ads?

That’s from over a year ago.  Home prices have fallen about 15% since then.  Hope you didn’t buy a house on their recommendation!  But seriously, who’s taking advice on housing from the National Association of Realtors?  If you are, you deserve what you get.

Go ahead and call me a conspiracy theorist, but of course the NAR has a bias.  Their core purpose is “to help its members become more profitable and successful,” which, given the existing compensation structure in Realtor-ville, can only be achieved through more home sales or home sales at higher prices.  Could you imagine somebody like uber-bear Nouriel Roubini as the head of the NAR?  I can’t picture it either.

The NAR’s Grand Poobah, chief economist Lawrence Yun, said a few weeks ago:

The housing market has decisively turned for the better.

There you have it.  It’s turned for the better!

Now, this is a guy who not only denied there would be a recession in 2008 as many economists were revising their forecasts downward, but adamantly asserted that home sales and prices would remain strong through the year.  Once the recession was officially declared and backdated to mid-2007, Yun said it would end rather quickly with unemployment peaking at 6.7% before steadily heading down and that home prices would – you guessed it – remain resilient throughout.  Goodness gracious!  It sounds like all the realtors around the country underneath him have a much more realistic view of today’s market.

I don’t mean to pick on Dr. Yun.  It’s a cheap shot and hindsight makes that easy.  As a fund manager, I know what it feels like being on the other end of that kind of criticism.  A block of our lives is unavoidably public.  We do the best we can with what we have, and a lot of times we’re just plain wrong.  On balance, all the old hands in this business have really thick skin and are adept at learning from their mistakes.  Those that don’t fall by the wayside and find jobs elsewhere.

Yun may have a very clear bias, and he may have been way wrong about a whole lot of stuff, but he is right about one thing: housing is key to sustainable economic growth.

It sounds trite, but rising home prices right now would solve a lot of our current economic problems.  I point this out because endemic in that solution is a problem that’s very deflationary.  This is why I think that all those that are super-freaked out about inflation are not only not living in the present, but too far out in the future.

Watch the health of this market.  It will require diligence and effort to stay focused on this, because let’s face it, the future of the housing market is pretty boring.  There is no money to be made (for the average person) in housing now or at any time in the next decade.  But there is money to be made by the individual who stays tuned in to this market, and understands the effects it has on other markets and the global economy.

The stock market has rallied something fierce this summer, but that rally hasn’t been confirmed by the housing market.  I know the stock market doesn’t revolve around housing, but 70% of the economy is consumer-driven, and consumer psychology has a lot to do with the health of the housing market.  If I’m making strategic long-term investment decisions in the stock market, I’d like to see some legitimate strength in housing, though at this point I’d probably settle for a clear, definitive bottom.

A crucial disharmony

As something of a behavioral economist with a foot and maybe an arm in the Austrian camp, I’m very interested in monitoring the psyche of the consumers in this market.  Right now, psychology in the housing market has suffered catastrophic damage after a near-fatal accident.  How long until that’s been repaired?  How long until the anchor of negative equity lifts and how long after that do we stop worrying it may happen again?  How long until our homes make us feel wealthy instead of poor?  This stuff is obviously very difficult to measure, but it’s of paramount importance to this market, and in turn, the global economy as a whole

When I talk to people about housing and ask them what they think about the future, I often hear things like “eventually prices will go up again,” or “now that it’s gone down so much it probably won’t go much lower.”

In a rational context these statements are, quite simply, false.

As we pointed out above, prices don’t have to go up again any time soon.  And the fact that they have fallen so far has very little to do with whether they’ll keep falling.  Home prices are dependent on a lot of factors, but most importantly,

1. How much current and future income individuals have available to allocate to a house.
2. How accommodative the environment is to enabling them to pay more money for a house.

What makes all this really interesting is that when I talk to people about the broader economy right now, I do not hear the same optimism regarding incomes and the credit environment.  Right now, most people seem to feel that the labor market is going to be a sticky slog for a long time and nobody seems to think aggregate incomes and wealth will increase the way they have in the last two decades.  And who do you know that’s optimistic about the credit environment?  Have you spoken with anyone who thinks that lower interest rates, lower down payment requirements, and lower credit standards are in our future?

The tiny psychologist on my shoulder wonders how people reconcile these two views.  The one is so clearly dependent upon the other.

Perhaps I’m missing something.  Markets of any type are heavily influenced by psychology, and efforts to understand this dissonance could be quite profitable.  I wish I had the answers.

I see now I could go on and on.  I haven’t even touched on rising foreclosures.  More and more delinquencies from all types of borrowers (not just subprime).  Historically high inventories and high months’ supply.  Historically low lumber prices.  The unknown ramifications of “Shadow Housing Market”.

Right before this letter went to publish, I discovered this from Whitney Tilson’s T2 partners; he went on for 155 pages so I don’t feel too bad about rambling.  Tilson’s a pretty smart guy and a rational voice.  He was on top the financial meltdown pretty much from the get-go.  The report is worth your attention but the faint of heart should probably stay away.

I realize now I could have saved myself a bunch of time over the last three weeks and just linked to this report!  Tilson does an embarrassingly better job with the material than I.

And now for something completely different

I promised you some good news, so we’ll close on a happy note.

Believe it or not, despite all my cynicism and skepticism, all of this mess actually gives me quite a bit of hope.  Our national spirit has not been defeated.

Americans are remarkable creatures.  Is there a more resilient, relentlessly optimistic body of people on earth?  The United States is the greatest success story in the last 2000 years and it shouldn’t surprise you that given the track record of our country, our people should be so universally bullish about our long-term future.  Despite our numerous failures and mistakes, we have emerged from each stronger, better.

Even during last fall as the world seemed to be crumbling around us (at least for those of us deep inside the financial industry), when I would talk about the crisis to people on both Main Street and Wall Street, the overwhelming consensus sentiment was: this is painful and scary, but we’ll get through it.  It was almost eerie, listening to this mantra chanted over and over again, soothing our collective anxieties and reassuring our faith in one another.  Really, we were all just in shock.

Today, in housing, activity has undeniably picked up.  Yes, it’s primarily distressed sales at the lower end.  Yes, it’s been driven in large part by incentives.  Yes, the jumbo and luxury markets are still a mess.

But you know what?  It’s better than a kick in the pants.

A bunch of new, performing loans are being written every day at terms that actually make sense for bank and borrower, straightforward loans with a much better equity cushion that improve banks’ prospects for long-term profitability and recapitalization.

As I mentioned earlier, the housing market is still stuck in this pre-Copernican mindset where it thinks that home prices are the center of the economic universe.  They aren’t.  The quality of the jump in sales activity may be poor, and this type of activity may not translate into stronger prices further down the road, but the quantity is good and the tangential effects of this increased activity are a positive thing for the economy at large.

So stop thinking about housing in terms of prices.  Adopt a holistic view.  I certainly hope I’m wrong about prices; I hope they stabilize soon and start trending upward.  But there’s more value to be realized by thinking about what weak prices mean in a broader sense.

I think it means things like lower consumer spending and sluggish economic growth.  It means less jobs for a long time in a lot of housing-related sectors, especially construction.  It means opportunities will be highly bifurcated – there will be lots of good stocks to buy and lots to steer clear from.  In late 2007, I adopted a blanket strategy of categorically avoiding financial stocks and anything too connected to the banks.  With all the uncertainty and toxicity still floating around out there, I think that’s still a prudent thing to do.

Stopping by the Woods on a Snowy Evening

Banks can’t pass the poison pig until its been fully digested, and a more active housing market is something that moves this process along.  In the meantime, our American DNA is slowly changing.  Tracking this change is interesting and predicting the effects of that change could eventually be of importance.

Right now, however, it’s like watching the woods fill up with snow.  Lovely, fascinating.  It might even be what really matters.  But we have a long way to travel still.  There’s a lot of mess to sort out.  A lot of assets with uncertain values.  An unknown economic future and unknown consequences of past and future government intervention.  There are miles to go before we all can sleep.

We have promises to keep.