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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The Fate of the U.S. Dollar

Fears of a “great fall” in the US dollar are widespread, and with good reason. US Government debt took on ghastly levels during the credit crisis. China has threatened to stop buying US debt, partially because of valuation concerns and partially because of politics. OPEC has threatened to change to an alternate currency for the trade of oil if the US dollar continues to lose its value. The saber rattling is intense, and the statistics look grim. But will the “great fall” occur, and if so, when? To find out, we need to fully explore the facts, and their relationship to the dollar.
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FACTOR 1 - Foreign Ownership and Trade Deficit

A current account deficit (when a country imports more than it exports) is a regular feature of the US economy. As long as the US is paying more to foreign countries than these countries are paying to the US, the US$ will continue to slowly decline. There is talk that because of this uncertainty OPEC and China are both considering moving away from investing in US dollars. The problem with this story is that there is no other currency that will suffice. The Euro has its own share of problems, with member countries having high debt levels. The Canadian $, Australian $ and other currencies cannot support the level of trade necessary. The US$ is, at present, still the only logical choice for International trade.

Direction –Short-term Neutral, Long-term Bearish

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FACTOR 2 – The U.S. Economy

At present, the world is rife with bubbles. Canada, China, and to a lesser extent the U.K. are experiencing housing bubbles. China also has a stock market bubble. Gold is firmly in fear territory. Paradoxically, what is usually the safest of the safe (T-bills and gold) are now amongst the riskiest.

The US economy, on the other hand, is in good shape for the future. Major asset bubbles have already burst. Unemployment is high but stabilizing. Home prices are already low and getting lower, to the point where an average-income family (with good credit) can once again comfortably afford an average home. Citizens are, for the first time in years, paying down their debts and saving. The banks have recapitalized and have greatly reduced their leverage. In short, the U.S. has experienced a great deal of pain, and is now trudging slowly toward recovery. This recovery is likely to firm at the same time as other bubbles in the world begin to burst.

Direction – Short-term Bullish

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FACTOR 3 – Demise of the Carry Trade

For the past two years, financial institutions around the world have taken advantage of low US interest rates, using the US dollar for “the carry trade.” The carry trade is the name given to taking out loans at low interest rates, and using these funds to invest in higher interest investments elsewhere (often in another country). For example, say a hedge fund in Singapore takes out a loan in US dollars. It may then convert the funds to Euros and invest the money in a German bond that pays a higher interest rate than the rate on the US loan. The result is “free money” to generate income.

Because of the carry trade, many US dollars have been sold (converted to other currencies). When the Fed starts raising interest rates, the US$ carry trade will reach a point where it is no longer profitable and hedge funds will have to pay back their US loans. That is, once US interest rates begin to rise, there will be a rush to exchange foreign currencies for US dollars to pay back loans, boosting demand for the US$ and therefore price.

Direction – Short-term Bullish

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FACTOR 4 - US Debt

The US, during the credit crisis, built up a huge amount of debt. Many worry that this will give the US an excuse to print money and debase the currency (since it’s better to pay back debt with dollars that are worth less). This reasoning is faulty for two reasons: the nature of the debt, and relative value.

Although the Government spent a lot of money during the credit crisis (and before it), the amount of money spent is of little relevance. What is relevant is the return on capital. That is, for every dollar spent, how much economic prosperity will that dollar create? Spending on such things as education and infrastructure (roads, communications) is important not only because it creates jobs immediately, but also because it leads to greater economic prosperity later on (rather like spending money on a University education). The recent spending spree may or may not create a good long-term rate of return – the verdict is still out.

Many people believe that the money the US Government leant to banks is “gone.” That is, that it was given to the banks and they spent it, and that it will now take years for them to pay it back. This is nonsense. Money was given to the banks because banks are required to keep a certain level of collateral on their books in order to operate (known as a Tier 1 Ratio). The money given to banks was simply deposited into the bank’s accounts so that they met the requirements to continue banking and giving out loans. Of the 2 trillion dollars given out for liquidity during the credit crisis, all but 100 billion has already been repaid, and the Fed fully expects the rest to be paid back sooner rather than later. The US taxpayer has not lost a dime in this endeavor.

Relative value is the fact that currencies are valued compared to each other. Although the value of the US dollar has dropped relative to, say, gold, it has retained reasonable stability relative to most other currencies. This is helped by the fact that Europe, Dubai, Canada etc. have recently run up their debt levels just like the US has (or worse). So, while US debt may be a matter of concern, it isn’t necessarily a concern for dollar valuation. In this regard, it is notable that whenever bad headlines hit the news, the US dollar rallies: that is, when trouble strikes, investors from all over the world still seek the safety of the US dollar.

Direction – Short-term Neutral, Long-term Unknown

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In conclusion, although US debt levels and trade imbalance are matters of concern, the short- and medium-term case for the US dollar is strong. The US is on the road to recovery, effectively two years ahead of the rest of the world. And, when the Fed begins raising interest rates the carry trade will collapse, urging the US dollar up.

Though the long-term crystal ball remains cloudy, the imminent demise of the US dollar has been greatly exaggerated.

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“The commodity value of the circulating media (paper money) is zero.” Binhammer and Sephton: Money, Banking, and the Canadian financial system.

Two Stocks I Like - Penny Stocks

The two stocks featured here are speculative plays. Neither company is currently netting a profit. Put another way, there is a very real possibility that these companies could fall into bankruptcy. Neither company has conclusively proven that their business model works. Nonetheless, these companies are innovative enough, and have enough “real” earnings potential to warrant some consideration. I own both.
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U-Food Restaurant Group (UFFC, OTC) www.ufoodgrill.com

U-Food Grill is a fast-food restaurant chain that focuses on healthy fast food: organic rice, low-fat cheeses, whole-grain breads, hormone-free lean meats etc. Their menu includes U.S. staples such as burgers and fries (baked), wraps, rice bowls, and salads. They currently have 10 locations in the U.S.

U-Food Grill’s official spokesperson is former heavyweight champion George Foreman, whose image is everywhere. George Foreman fits in perfectly with the healthy image of U-Food, as well as the “healthy grilled food” concept made famous by his George Foreman Grill.

U-Food initially got killed during the credit crisis, as its prices were significantly higher than traditional fast food outlets (between $8-14 per meal). Now, their prices are in line with other fast food restaurants ($5-10 per meal). The recession also, I think, helped U-Food define its long-term strategy. They recognized that their restaurants do best in areas with above-average incomes, or where there is a real demand for healthier fast food. In response, U-Food is now focusing on opening restaurants in hospitals and airports.

Stock Price (at time of writing): $0.073 USD

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HearAtLast Holdings (HRAL, OTC) www.hearatlast.com

This company is a Canadian-based retail store with 28 locations, specializing in mid- to high-end hearing aids. HearAtLast formerly opened small shops that competed with local hearing aid stores, but changed its strategy a couple of years ago, choosing instead to be co-branded with a large retailer: Wal-Mart Canada.

I visited HearAtLast’s location in the Wal-Mart megastore in Westbank BC in 2009, and got a tour of the location from the local manager. Customers who suspect hearing trouble start with a simple test using a set of headphones. If their hearing is not perfect, an appointment is made for a rigorous test in a sound-proof booth (located in back). If necessary, an appropriate make and model of hearing aid is afterward presented to the client. The store was clean, sharp, high-tech, and located right at the entrance & check-out area. Perfect.

Stock Price (at time of writing): $0.0585 USD
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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.