Stagnation in the Canadian Housing Market

A LESSON IN TIMING, INCENTIVES, AND PSYCHOLOGY

The Aug 8^th 2012 edition of Canada’s Globe & Mail newspaper boldly stated that the country’s economists had reached a consensus: the bloated housing market will first slip 10-15%, and then “stagnate for years.”

The Frost Report has been warning prospective buyers about the coming decline of Canadian (and world) home prices since the first peak of February and March 2010 (see Spin City).  So, why are economists lagging so far behind?

First, the news is coming out now because it can.  The economists in the article -- who are employed by financial institutions -- have nothing left to lose since the market is “effectively exhausted” (their words).  People who have already bought homes have given the banks and brokerages their business, and can no longer benefit from the advice.  Those who don’t have homes after years of low interest rates either can’t afford them or don’t want them.

Secondly, economists have virtually no natural incentive to accurately predict slowdowns and price declines.  Nasty predictions about the most popular investment in the country (real estate) are unpopular, unwanted, and of no benefit to the companies who employ economists.

And then there are the clients…

It’s dangerous to advise a client not to buy real estate.  Contrary to what is taught in most investment psychology manuals, clients take declines in prices (“who could have known?”) far better than missed opportunities (“you said not to buy and prices went up 50%!”).  Furthermore, a client who has already decided to buy (which is typically why they are speaking with a banker or real estate agent in the first place) will never, ever listen to advice anyway.  If a client, who has already decided to buy, asks a banker if it’s a good time to do so and the banker replies, “I don’t believe it is,” that client will usually spend the next 15-20 minutes explaining to the banker why he is wrong.

The Cinderella party in Canadian housing is officially over.  I sincerely hope that the moderate 10-15% decline predicted by the nation’s top economists is accurate – but I doubt it.

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See also:

Canadian house prices to slip, then likely stagnate for years

Summer chill cools Toronto, Vancouver property markets

 
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Forget Greece and Italy

Greece and Italy have been stealing economic headlines these days.

The media has been so focused on Greece and its pint-sized economy, that they have completely missed what should really be headlining world economic news…the slowdown of the world’s second-largest economy.

China’s government-induced GDP growth and red-hot housing market have both stalled.  Ironically, the government itself caused the slowdown, as it introduced prudent anti-bubble measures throughout the year.  Such measures were an unfortunate necessity: without them, inflation was turning rampant.  But now the slowdown may turn out to be just as devastating.  And, it seems that the largest companies in the world are well aware of what is coming.

Last week, Goldman Sachs sold $1.1 billion worth of its shares in Industrial and Commercial Bank of China (1398.HK).  This week, Bank of America announced it was selling the remainder of its shares in China Construction Bank (0939.HK) – $6.6 billion worth.

Today, the International Monetary Fund announced that Chinese banks could suffer “huge losses” on the very extreme case that credit shock, currency shock, and yield curve shocks were to occur together.  Interestingly, this “slim and rare occurrence” appears to already be starting.

The IMF's Jonathan Fiechter stated rather bluntly stated (as far as economist-speak goes) that "while the existing structure fosters high savings and high levels of liquidity, it also creates the risk of capital misallocation and formation of bubbles, especially in real estate." In other words, the current government’s financial policies force people to invest in real estate (since buying other asset classes in China is considered too risky), and, banks are lending too much to capital projects with no economic future (again based on government direction).

One could say that the Chinese economy is a centrally-controlled “our government knows better” economic marvel mess.

It is my advice - stated on several occasions previously - that you follow the lead of Morgan Stanley, Goldman Sachs, and Bank of America; that is, sell all but your very best Chinese holdings.

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See also:

China faces grim foreign trade outlook

China's property cost curbs to remain despite home price drop

China’s CCB Plays Down BofA Share Sale Impact

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Canadian Debt Levels Hit Record

In a speech this week that was as straightforward as possible, Bank of Canada governor Mark Carney told the crowd at the Economic Club in Toronto that "low rates today do not necessarily mean low rates tomorrow. Risk reversals when they happen can be fierce; the greater the complacency, the more brutal the reckoning."

Mr. Carney was, of course, referring to Statistic's Canada's announcement that household debt ratios have hit a record high, and that people could get stung badly if rates increase. Statistics Canada's announcement was surely a frustrating development for Mr. Carney, who has been warning Canadians about their debts for over a year.

The debt-to-income ratio for Canadians is now higher than that of Americans - a fact which many Canadians likely refuse to believe, since their self-image is that of financial prudence compared with their Southern neighbors.

Dangerously, these record debt levels coincide with unusually high home prices and unusually low interest rates: a situation that could easily lead to the double-whammy of rising payments on falling equity values - a sure formula for financial disaster.

Meanwhile, deaf ears continue to buy new condos and pull out the plastic for Christmas shopping. It is likely that most indebted Canadians will never read this article, or, for that matter, give it a second thought even if they do.

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"It’s a matter of concern but it’s not a matter with respect to which we’re going to act immediately."

Jim Flaherty, Canadian Finance Minister, December 2010, when asked if Canadian personal debt levels are a concern.

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See also:

Canadian Debt Levels now Higher than Americans

Chinese Real Estate - the Time Bomb keeps ticking

Back in April, I recommended selling the Chinese market short, a move which many thought "suicidal." Chinese industrial numbers at the time looked fantastic - and still do. Nonetheless, the Shanghai Composite Index tanked exactly as I suspected, going from 3130 to 2365, a 32% loss (providing a 32% gain for short-sellers) in only two and a half months.

The market has since recovered slightly (to 2560), and the world economic picture looks somewhat brighter. So the question is, should you finish taking profits or keep the short sale going?

Despite drastic government measures, the euphoric mood of the Chinese market appears to have barely subsided. Prices remain stratospheric. Speculation remains rampant. Gleaming condos continue to rise.

A Xinhua news agency article from July 24th (Realty trouble in the offing), recognized that the housing bubble is still out of control, bluntly noting that "skyrocketing housing prices are the outcome of artificial speculation." In addition to calling the market "bloated," it adds that price rises could result in "social conflicts and lead to social unrests."

No, the Chinese meltdown is not over. But, the market fall may take a short hiatus (ie. make a slight recovery) as the world situation temporarily improves. Hopefully not for long, however, since the longer the Chinese euphoria lasts, the more devastating the final fall will be. Be ready to sell short again when the market plateaus.
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This will likely be the last article for the next two weeks, as I am off to Shanghai to find out about the market firsthand.

Thank you for reading The Frost Report.
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Additional reading: Sell the Chinese Market Short
Big realty program to solve house woes
Foreign investors eye China's realty market

The Canadian Real Estate Market: Trouble in the Pipeline

The Canadian Housing market is going well, with big volume and qualified customers. At least, that’s the current perspective at the end of the line. The further one goes up the pipeline, however, the worse the big picture looks.

A mortgage department employee from a major bank recently told me that application volumes are down 25% or more since June 15th. Though employees are not being laid off, those who leave or retire are not being replaced. At the same time, the quality of mortgage applications is deteriorating rapidly (“scraping the bottom of the barrel” was the exact expression).

Further up the pipeline, Real Estate agents tell me they are worried. Sales have dropped noticeably since May. In an attempt to make up the difference, agents are cold-calling and self-marketing like they have not done for a very long time.

Of course, all this is anecdotal evidence. At the bank level, sales numbers still look great. Yet, I suspect that the drying mortgage pipeline will reach Canadian banks soon. When it does, you will read about it here.

For further information, see:

Spin City
Canadian Debt II
World Housing Bubble II
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"Phew. With yesterday's report that home resales are cooling and price increases shrinking, we can finally put behind us the horror of Canada's great imaginary housing bubble. ...What Canada had was modest overvaluation with very little sign of speculation."

Jay Bryan, The Montreal Gazette, June 17 2010.

The World Housing Bubble - Part II

Just in case you thought it was over...

Back in March, The Frost Report noted that during the economic crisis of 2006 and beyond, countries around the world drastically lowered interest rates to spur economic growth. Like the Frankenstein monster, the good intentions of these low interest rates have morphed into a hideous mess: a multinational, worldwide housing bubble.

Some economies have already moved from the "we don't have a bubble" stage to the "bubble is beginning to burst" stage, while others are still recovering from the first one. In case you missed the original article or it has faded from memory (see: World Housing Bubble), here is another selection of this year’s headlines to remind you that the problem is far from over.

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THE UK

House price rises ‘unsustainable’ as lending falls
The Times, June 2nd 2010

"Vicky Redwood, Capital Economics’ senior UK economist, said that the data 'continues to suggest that the recent rise in house prices is unsustainable'."

http://business.timesonline.co.uk/tol/business/industry_sectors/construction_and_property/article7142355


CHINA

May property sales plunge in Beijing, Shanghai, Shenzhen
Xinhua, June 2nd 2010

"Beijing, property signings slumped nearly 70 percent to 3,357 in May from April, the Shanghai Securities News reported, citing data from the city’s housing regulator. In Shanghai, transactions may have dropped about 70 percent to 2,550 signings, the paper reported, and in Shenzhen, sales fell 62 percent."

http://news.xinhuanet.com/english2010/business/2010-06/02/c_13328894.htm


AUSTRALIA

Interest rate rises subdue housing bubble
The Australian, June 1st 2010

"The Reserve Bank of Australia's rate rises have pricked the boom in housing prices and have also sent lending to businesses skidding into reverse."

http://www.theaustralian.com.au/business/property/interest-rate-rises-subdue-housing-bubble/story-e6frg9gx-1225873746105


KAZAKHSTAN

National Bank Chairman: Kazakhstan Focuses on Economic Recovery
Ministry of Foreign Affairs, May 4rth 2010

"Kazakhstan was one of the first countries to experience the global economic meltdown of credit. As a result, it was one of the first to respond with a comprehensive program to deal with problem sectors, such as banking, financial services and property development — the industries that created an economic ‘‘bubble’’ whose collapse the country is still recovering from."

http://portal.mfa.kz/portal/page/portal/mfa/en/content/news/ASTANA%20CALLING/2010-05-04


KENYA

As Nairobi Property Prices Rise, Home Buyers Suffer Low Returns
AllAfrica, Feb 22nd 2010

"Many people who have taken mortgages to buy rental properties are finding it increasingly difficult to service the loans since rents accrued are not sufficient to cover the monthly mortgage repayments.
At the heart of the problem is the fact that rents in many parts of Nairobi suburbs are facing a property price bubble."

http://allafrica.com/stories/201002221638.html


ISRAEL

Legal Ground: The end of easy mortgages?
The Jerusalem Post, May 28th 2010

"It was predictable that the Bank of Israel would move to cool the residential mortgage market. We have seen what anarchy of easy mortgages could do to a massive established economy like that of the US. Even more so, the collapse of a bank in a small economy such as Israel could be a disaster."

http://www.jpost.com/Business/Commentary/Article.aspx?id=176747


CANADA

House prices to drop: TD
The Globe and Mail, May 5th 2010

"House prices will fall in 2011, TD Bank said Wednesday as it revised its outlook for the Canadian real estate sector."

http://www.theglobeandmail.com/report-on-business/house-prices-to-drop-td/article1557540


TAIWAN

Taipei Real Estate Risks Grow After Record Rally
Bloomberg, May 20th 2010

"Investors should sell Taipei property now, taking advantage of a 21-month rally in prices before the government acts to make real estate more affordable, according to the Taiwan Real Estate Research Center and the island’s largest real-estate brokerage."

http://www.bloomberg.com/apps/news?pid=20601206&sid=a0cIUQ74Wfy0
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After today’s “hot economies” become tomorrow’s “busted economies” and real estate prices return to normal, the world map of economic health will need to be redrawn. Those with developed infrastructure and the ability to raise taxes will fare better, while emerging markets will likely be hardest hit.

If you have a margin account and/or trade international stocks, it would be wise to raise some cash (if you haven't already), to take advantage of bargains as they come available in the next 18 months.

Despite ongoing domestic problems, it is my belief that in a few years the United States - whose massive deleveraging has preceded and superseded all others - will look enviously safe and stable.

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"...in an environment in which the financial sector is prone to excess and the supervisory structure does not respond sufficiently, the interaction of low interest rates and financial vulnerabilities can clearly be dangerous."

Donald Kohn, Federal Reserve Board, 2010

Abouuuuut….Face!

The CREA Gets Real




Just seven days ago, I wrote an article stating that the Canadian Real Estate Association should be ashamed of themselves for their cheery and completely unrealistic assessment of the Canadian housing market (see: CREA to the Rescue).

Today, in a stunning about-face, the CREA "updated" its forecast, admitting that by 2011 a "demand-driven downturn" will push Canadian home prices lower. They even added that the threat of rising interest rates and new taxes caused buyers to jump into the market sooner than they may have otherwise (something I wrote about in April, in Spending 'til it Hurts).

It’s unclear what prompted the CREA to come clean. I’d like to think it was my blog, but more likely they simply realized that a small dose of reality now prevents egg-on-your-face later.

Of course, the CREA is still being idealistic (read "deceptive"). Amongst other nonsense, they insist that Canada’s "conservative lending practices" and mythical "prudent borrowing" will prevent a large price correction; that the two most overpriced markets (Ontario and B.C.) will inexplicably plateau next year after a small drop; and, of course that the current market shows a good balance between supply and demand. But, at least they aren’t encouraging a new wave of oblivious buyers. The CREA has, with its latest press release, gained back a shred of dignity.

I have to give credit where credit is due: the CREA did the right thing. More of the same would be nice.

For the CREA's full press release, see Housing Forecast Revised.
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"Home sales are coming down from the mountain peak, but they will level out at a high plateau -- a plateau that is higher than previous peaks in the housing cycle.”

David Lereah, Chief Economist, National Association of Realtors, USA 2006

Cognitive Dissonance

INVESTOR PSYCHOLOGY




Improve your investing by improving your way of thinking.





"Cognitive dissonance" is the name for anxiety caused by disconcerting thought processes. That is, when people are faced with facts that make them uncomfortable, they tend to ignore these facts, literally to the point of self-denial.

Cognitive dissonance is the reason why a mother won’t accept that her son is dead, even when the police are standing in the doorway telling her. Cognitive dissonance is the reason why a husband with an unfaithful wife will always be the last to know. It is why those in debt do not open their mail. It is why Al Capone thought he was a good person because he donated to charity. And, it is why Americans who wished to buy a home in 2006 (or already had one) insisted that there was no housing bubble, despite all evidence to the contrary.

It is a natural thing for people to seek confirmation of their existing beliefs. Finding facts to prove you are right is both satisfying and comfortable. This is why conservative Republicans watch Fox News, anti-globalization protesters read Noam Chomsky, and why environmental activists seldom read the Oil and Gas Journal. But in order to be a truly effective thinker, one must embrace cognitive dissonance by intentionally seeking disconfirming evidence. For many great thinkers, including investors Charlie Munger and George Soros, the best technique for embracing cognitive dissonance is a simple one known as “Inversion.”

Inversion states that in order to prove that something is true, you should try to prove it false; that is, for any strong belief that you have, regularly search for evidence you might be wrong. If you wish to buy a stock, for example, you would include a search for reasons not to buy it. You would read not just the glowing press releases about the company, but also seek out all negative facts about the company, and judge these facts without emotion. Only after finding no significant reasons not to buy the stock would you actually buy it.

Cognitive dissonance is not easy to overcome. You will be fighting natural human emotion every step of the way. Despite a lifetime of working on it, I have fallen prey at least twice, and will no doubt do so again. But by making a habit of questioning your own judgements and attempting to prove your own beliefs false, you will become a stronger and more reliable investor (and possibly a better person). Soon, you will find that your mental discomfort becomes a source of pride and pleasure, not to mention lucrative.
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“Faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.”
John Kenneth Galbraith

Greek Debt Bailout – What Happens Now?

The Greek (actually Euro) debt crisis has been, at least temporarily, averted via a $1 trillion rescue package that could really be looked at as a “render predatory traders useless” package. Now what? Is the EU set to recover? Is everything just fine?

Despite these efforts, much of the world including the U.K., Canada, Israel, Dubai, Korea, China etc. (see: World Housing Bubble) are set to stagnate and/or enter recession within the next 18 months. In these countries, economic recovery has been more about new housing bubbles and consumer credit growth than real recovery.

Although the U.S. was the instigator of the worldwide collapse, it is now in the best position to move forward (no one said life is fair). The U.S. has inexpensive housing, low interest rates, a devalued dollar, moderately valued stocks, citizens with reduced debt, and increased productivity - all of which give the U.S. economy plenty of upside potential.

Under normal circumstances, a multinational recession would not bode well for U.S. stocks and I would say, “sell.” However, the current situation is more complicated than that. American stocks today are priced at levels that reflect modest post-recessionary income and a definite lack of euphoria. Even if world markets slow down, it is already priced into U.S. stocks at this level.

Secondly, you may have noticed that although world markets are global and affect each other, it is mostly the U.S. market that affects the rest of the world – and not the other way around. Even when a powerhouse like China experiences market drops, for example, the effect on the U.S. market is negligible. I suspect that when world markets decline it will bring down the American market only temporarily, until everyone realizes that U.S. growth is sustainable domestically at a level that supports and even exceeds today’s stock prices.

In short, most Commonwealth, EU, Arab and Asian countries have, at this point, little or no room on the upside, but plenty of room on the downside. Conversely, U.S. stocks that grandmothers around the world are still afraid to buy are the best investment opportunities around.

Many high-quality U.S. stocks, including members of the Dow 30, remain at single digit or low-double digit P/E levels, even on modest sales. If prices drop from here and you are a long-term investor, I recommend going against the grain and buying more, since any dip below today’s reasonable prices is a blessing. If you are afraid of volatility in your portfolio (there is sure to be plenty), ignore all this advice and stay away from the cheap-stocks party.

PS - The International cheap stocks party should begin sometime next year.

Statistics (at time of writing)
Dow Jones Industrial Average: 10,785
Hang Seng: 20,320
FTSE 100: 5,385

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"These high prices [in the Dow] were the cause of great jubilation on Wall Street, but I found them depressing. I was happier with a good 300-point drop that created some bargains."
Peter Lynch, Beating the Street
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Disclosure
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

Spin City

In recent days, both the Canadian Real Estate Association (CREA) and the Canadian Mortgage and Housing Corporation (CMHC) have been coordinating the same message to potential homebuyers: sales have dipped slightly, while listings & housing starts are rebounding, which is leading to an “improved balance between demand and supply.” The result, we are told, will be stable or modestly increasing home prices, simultaneously proving that the bubble everyone was whispering about was false. We can all breath a sigh of relief, and go out to buy that condo.

Personally, I find this spin-doctoring offensive. The CREA argument about supply and demand is rather like arguing that the Nasdaq was not overpriced in 2000, since there was a balance in demand for Internet stocks. In fact, one characteristic of bubbles is that demand suddenly plummets when people realize that there is no one left who wants to buy. So, to know the real story, we have to talk not about supply and demand, but rather about valuation.

By financial standards, a home is considered “comfortably affordable” if monthly mortgage expenses are 32% of pre-tax monthly income or less. As this number increases, one’s standard of living becomes increasingly tenuous. When monthly debt payments reach 40% or more of income (including mortgage payments, car payments and others), financial survival becomes a struggle.

The facts about Canadian housing are straightforward. According to RBC research (November 2009), if a median-income family bought an average 1200 sq ft bungalow in Canada, their monthly payment would be 40.2% of pre-tax income -- well above the 32% recommended, and in fact already above the monthly limit for total debts. In major cities, the numbers look even worse. In Toronto an average home requires 48.6% of pre-tax income: in Vancouver, 66.8%. This effectively means that if an average couple bought an average home in Vancouver, they would pay their income taxes, make their mortgage payment, and have nothing left.

And, the above statistics are the case today. Canadians, normally known for financial prudence and common sense, have actually been increasing their personal debts – not paying them off -- since the credit crisis began. The Bank of Canada stated that, “overall risks to financial stability arising from the household sector have continued to increase.” If current interest rate and savings estimates remain unchanged, Canadian debt payment levels will reach record highs by the fourth quarter of 2011. By the middle of 2012, roughly 1 in 10 Canadian households will have debt payments that leave them “financially vulnerable.”

In order for home prices to remain at current levels, one of the following must occur:

A) All homes and condos built from this point forward must be bought by foreigners/immigrants (since locals are already incapable of safely purchasing homes at today’s prices).
B) Wealthy investors must buy -- and continue to buy -- multiple homes for speculation, and keep them for years.
C) Wages in major cities must increase by approx. 8-30% (depending on the city) within the next 12 months, with no rise in unemployment.
D) Home prices must drop.

I can’t blame the CREA for their rosy interpretation of the numbers; after all, their mandate is to represent “more than 98,000 real estate Brokers/agents and salespeople working through more than 100 real estate boards and Associations.” With such allegiances, it seems unlikely that the CREA would ever say, “we think homes are overpriced and that you should wait to buy one.” Still, for the CREA to pooh-pooh the notion of a real estate bubble by citing supply and demand is either foolhardy or immoral.

Ockham’s Razor states that for any given problem, the simplest explanation is generally the best one: Canadian home prices must drop. For the record, my educated guess (it is only a guess) is that this drop will begin sometime between the 3rd quarter of this year and the 4rth quarter of 2011. And it will be nasty.
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“There is virtually no risk of a national housing bubble based on the fundamental demand for housing and predictable economic factors.” David Lereah, former chief economist of the National Association of Realtors, 2005 U.S.A.
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U.S. Robin Hood Real Estate

This week, President Obama announced revisions to the mortgage bailout program, giving the hardest hit states additional support. But when clients can’t pay – or simply don’t want to pay – will modifications help? For many of these borrowers, it was all-or-nothing from the beginning.

Back in June of 2007, customers would walk into my office saying, "I'm going to buy this house, redo the roof, sell it, and make a hundred grand!!” (During a bubble, people never say “thousand.” they always say "grand.") “But,” they would add, “we have to do it right away, because this market won't last forever!" Other clients would admit, "I don't have the money to buy supplies for renos, so I'm going to buy them on my credit card. It’s no problem. I’m going to flip the place in a month anyway."

In other words, people were intentionally making financially dangerous decisions, knowing full well that they were buying into a bubble. I saw little of the innocent “I didn’t understand the paperwork” crowd that made appearances on TV later on. And when I declined their mortgages, they got angry: "If you won't give me the money, I'll just go to someone else who will!" (I was, after all, denying them their once-in-a-lifetime opportunity to get rich.) If you're 40 years old and your only assets are a Harley-Davidson and some tools, why not risk everything? After walking out of my office, they probably went to a high-risk lender, got approved, and then our bank stupidly bought back their mortgage through a CDO.

Now we are giving them more money. I would like to see the U.S. housing market recover more quickly, just like everyone else. But instead of setting a dangerous precedent, the Government should continue to increase productivity through infrastructure renewal, keep interest rates low, and wait until the market drops low enough for the savers (of which there are many) to buy the homes. That is, stop bailing out gamblers and let the market work itself out.

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