Saturday, March 30, 2013

Behind The Curtain Of The Artificial U.S. Residential Home Market

I came across an excellent article this week on housing titled "Your House Is An Undiversified Bond Investment." The author reviews many of the concepts that I have discussed here over the past few years; specifically the importance of interest rates on the future value of real estate. For a review please see:

2013 Outlook Part 7: Home Prices Have Not Bottomed

You do not need a calculator to understand that a monthly morgage payment of $1,000 is very different than a monthly payment of $2,000. There is no rational analysis that exists showing how rising interest rates can be positive for housing. The following shows the long term fall in 30 year mortgage rates which may have finally reached their epic low (coinciding with the recent rise in the 10 year treasury bond):

While interest rates are important, there are many factors that play into the fundamental analysis of future price direction. On the other side of the ledger you have the income needed to pay the mortgage. You can track the health of this metric by following the median income in the United States. As you can see in the chart below, real wages have plunged and tracked sideways. This does not bode well for the income support needed to make higher mortgage payments.

A third factor is the cost of living, or the cost of everything else a homeowner needs to pay for every month. For example, if the cost of gasoline, food, utility payments, health care, college tuition, and everything else a homeowner must pay out every month is falling then they have more room at the end of the month to make higher mortgage payments. What we have seen unfortunately is the exact opposite. The following chart from shadow stats shows the government's consumer price index which has essentially been above 2% for a decade (red line). Shadow stats shows a more realistic cost of living increase which has been rising about 5% annually over the last decade (blue line).

Residential real estate has seen a major force come into the market over the past year that has provided a major boost upward in prices. Large investment funds have entered major markets with large swaths of cash to purchase homes to rent out. How do we know that these cash buyers have been the major driver of home prices? The following chart shows mortgage applications (real working family buyers), which have plunged and flat lined.

Since home prices experienced their first dramatic dive back in 2007, we had the tax credit buying in 2010 that created a brief blip upward in pricing (and sent everyone into euphoria). When that passed prices resumed their downtrend. Most recently we have seen the investment buyers enter the market, shown below, creating the next push higher (and the next round of real estate euphoria).

This enormous new demand has been countered with banks holding millions of home off the market, creating the ultimate 1-2 punch of both artificial demand and supply. We can look to Las Vegas for a perfect example of this phenomenon because it is a city that has experienced a recent (unexpected) price surge. I highly recommend reading the following article in full from a local real estate agent in Las Vegas, but I will provide just a taste of it below.

From the Las Vegas Review Journal: "Anyone Else Hear The Housing Bubble Inflating?" by Steve Hawks

State and federal policies that were supposed to support home ownership have backfired and become anti-homeowner. The policies have locked out future Las Vegas homeowners.
AB 284, enacted in 2011, had good intentions, but the results have been disastrous for the Las Vegas real estate market. Most bank servicers have not been able to file notices of default since October of 2011. This has created an artificial shortage that is unprecedented.
There are now 380 bank-owned homes available on the market, 466 short sales on the market and 2,290 traditional sales. These traditional sales are mostly flips and investors unloading near the peak. Fifty-nine percent of mortgages are still underwater in Southern Nevada.
What’s so astonishing about those figures is there is no real shortage. There are 50,000 vacant homes in the valley and average owner-occupants have slim to no chance of winning their offers.
After the passage of AB 284, many homeowners realized they could live for free for long periods. Thousands of homeowners are on years three and four without making a mortgage payment. Lender Processing Services reported a few months ago that the average person who stopped paying has been in his home more than 24 months.
This trend, that I have been describing here month after month in detail, is taking place in major cities across the country. In the years ahead all these trends will reverse making this most recent housing rise even more artificial than the government housing credit. 
1. Banks will unload the inventory of homes currently being held off the market
2. Investors will begin to see rent declines as this new supply of homes floods the market and the real economy (jobs and income) does not improve. They will begin to unload their recent purchases onto the market as sales. This is already beginning to happen, see 2005 Or 2013? Developers Hosing Lavish Parties For Get Rich Quick Speculators.
3. The final bastion of hope for the market, lower interest rates, will reverse surprising everyone and pricing potential home buyers out of the market.
h/t Charles Hugh-Smith, Zero Hedge, Shadow Stats

Austerity: The History Of A Dangerous Idea

While I like to find most of the books I read through recommendations online, once or twice a month I like to walk through the business and economics section of the bookstore just to get a feel of the general mood in the market.

During the housing boom days there were up to six huge sections of real estate investing books, sometimes equal to the amount of all the other business, finance, and economics books combined at the store. After the credit crisis there was an endless release of doomsday books on what happened and how we will never recover.

Over the last two years there has been a new collection of "boom" books and how to make money in the "new growth economy." Essentially going to the bookstore, other than a few select forwarding thinking authors that I recommend here, is a review of what has happened over the past two years and may be the worst possible thing you can be reading. Rear view mirror reading.

Today I came across a book that sums up the dangerous and borderline insane material that is now being placed on the bookshelf. The book is called "Austerity: The History Of A Dangerous Idea."

In the early part of 2012 I discussed how the Federal Reserve's reckless monetary policy combined with the United States government's reckless fiscal policy would be disastrous beyond the damage it does to the United States (which will be horrific).

The real danger will come from countries outside the United States. Many up to this point (specifically in Europe) have at least been talking about doing the right thing, and in some cases even implementing it. By doing the right thing I mean cutting government spending and making investors take losses on terrible investments (Greek government bonds were written down, Cyprus depositors are losing money over the insured amount when the banks fail, etc.)

During this entire time Europe has felt pain. While this has been occurring they have looked across the pond to the United States (as has the rest of world) and watched as the economy appears to have recovered. They see the United States stock market soaring, they see real estate prices rising, and they see bond prices at an all time record high. This has occurred while the currency has strengthened.

A true economic miracle.

The danger of course (which is already beginning to happen) is that the European politicians will give in and let the European Central Bank monetize all the terrible investments across the European Union, just as the Federal Reserve is printing money to monetize trillions of toxic debt in the United States.

Seeing the "economic miracle" in the United States, the U.K. and Japan are changing course and upping the dosage of the poison to their economies as well; more government spending and more printed money. It is the miracle drug that never has consequences, until it does.

The argument against this is that without pumping this poisonous drug into the arm of the patient the United States economy would be in a much worse place than it is today.

I disagree completely.

I do believe that 2009 and 2010 would have been FAR worse in the United States if they had not pumped artificial drugs into the economy. What would have happened:

-stock prices would have collapsed further
-real estate prices would have collapsed much further
-many more banks would have failed
-interest rates would have risen significantly
-unemployment would have reached much higher levels (perhaps twice as high)
-inefficient businesses would have failed
-the price of almost all goods and services would have collapsed


We would have reached a bottom. The malinvestments in the economy would have been cleansed. Balance sheets would have been healthy.

Banks, not the government, would begin lending on real estate at much lower prices allowing new buyers to take on far less debt when they purchased. The cost of gasoline, food, medicine, and everything consumers purchase every month would be drastically lower. Those that saved their money, instead of recklessly investing it into bubble assets, would be rewarded with a large return on their investment every month with higher interest rates. Money would move into efficient sectors of the economy, instead of back into bubble assets like real estate and government driven sectors where investors today are just chasing yields.

The United States would already be growing again. Real growth. Instead we chose to pump as many artificial stimulants into the economy as possible, and we have not even begun the process of healing the economy. We are not in the first inning of recovery. We are in the last inning of the bubble economy. The 70 year debt super cycle that politicians will not let cleanse.

At the peak of this madness we now have "Austerity, The History Of A Dangerous Idea."

Years from now a book like this will go on the shelf alongside some of the all time classics including the following released in 1999:

And perhaps the greatest treasure of all released in 2005 by the head of the Realtors Association.

I do not want to trash this author without allowing him to provide his side of the argument. The following is the author, Mark Blyth, describing why austerity is so dangerous:

Thursday, March 28, 2013

The New America: It Is Better Financially To Collect Disability Than Take A Job

Rick Santelli discusses an NPR article titled "Unfit For Work" released this week that is an absolute must read. He hits on some of the highlights, but what I found most fascinating is that the top two leading reasons for disability today are back pains and learning disabilities, both of which are extremely difficult to disprove.

An American today has the option of going to the doctor with back pains and collecting $13,000 per year with medical insurance (while relaxing at home) or working hard at a minimum wage job for 40 hours a week collecting about $15,000 per year most likely without medical insurance.

How many people stay on this gravy train once it starts? Fewer than 1 percent of the Americans on disability in 2011 have returned to the work force. The article discusses the incentives to keep a child performing poorly in school in order to continue to receive a $700 a month check for their inability to succeed in the classroom.

Welfare programs cost the state money, while disability is a federal costs. As Santelli points out, these 14 million (and growing rapidly) newly disabled Americans are removed from the labor force and not counted as unemployed.

Another sign of recovery in America during the new depression.

FDIC Review: What Backs American Bank Accounts?

I covered this topic extensively in 2009, but it is a good time for a quick review with everything that is taking place in Cyprus. People assume in the United States that their money in the bank is completely safe as long as they hold it in an FDIC guaranteed deposit.

The following graph shows what the FDIC has in reserves (blue line) to back the deposits (red line). It shows that if there was a major bank failure or just a small fraction of the reserves were removed, the FDIC would be out of money in minutes.

The actual totals are over $9 trillion in deposits and less than $25 billion in capital at the FDIC. At a point in 2009 the FDIC actually had a negative capital base, which made this story even more laughable (they borrowed from the federal government to stay alive).

If the United States ran into a Cyprus situation (which they will), 3 things would need to occur for an American to get their money out of the bank:

1. The FDIC would need to agree to back the deposits. We just discussed that they actually have no money so they would immediately place a panicked phone call to the federal government.

2. The federal government would need to agree to back the FDIC. We have discussed many times that the federal government actually does not have any money. The government runs trillion dollar deficits every year and has a negative $17 billion balance sheet. They only exist due to their ability to borrow. Upon receiving the phone call from the FDIC, the federal government would immediately place a panicked phone call to the Federal Reserve.

3. The Federal Reserve would need to agree to print the money to back the federal government. How much would they need to print? $9 trillion as shown above to cover the deposit base.

The following chart shows that the Fed has monetized over 50% of the United States debt since 2009. They are on pace to monetize over $1 trillion this year, which will be more than the entire annual deficit.

Remember that if you lend your money to the bank, due to the fractional reserve banking system, that money is immediately removed from the bank and lent out. The FDIC guarantee allows banks to be completely reckless with the deposits. 

The entire financial system is backed up by confidence. Nothing more. There is no money at the banks. There is no money at the FDIC. There is no money at the federal government. It is a paper trail of I.O.U.'s.

Will there be a bank run in the United States tomorrow? Very unlikely. Will there be a bank run at some point in the United States for a banking system that is completely insolvent? It is 100% guaranteed.

Sunday, March 24, 2013

Influence: The Psychology Of Persuasion

I had the pleasure this past week to read Robert Cialdini's "The Psychology Of Persuasion." It is the compilation of Cialdini's life work where he has studied why people make the decision to do things. It focuses on business, sales, marketing, relationships, and every day life decisions that take place in the world around us every day (most that we rarely notice or think about). While some of the decisions are rational, other are completely irrational and Cialdini describes why those decisions are made, how you can avoid making them when they arrive, and how you can use the power of Influence to motivate others around you.

While he does not specifically reference the financial markets you will see that many of the topics translate seamlessly into the irrationality occurring both around the world today and throughout history. I will reference specific chapters of the book in the future when I discuss certain psychological occurrences as they come in real time.

The following is a brief illustrated view of just a few of the topics discussed in the book, which I highly recommend you put on your spring and summer reading list.

Is Cyprus The Canary In The Coal Mine?

Jim Rickards and Chris When, two of the brightest minds in finance today, discuss what is taking place in Cyprus and the impact on the global economy.

U.S. Stock Prices & Sentiment Levels At Maximum Danger Points

Most of the financial articles written today discuss how stocks are historically cheap and then go on to provide a long list of reasons why we are in the first inning of a new bull market. Most of these experts work for firms that profit in the form of commission fees when customers purchase stocks through their company or invest in their mutual funds. Similar articles were written by Realtors back in 2006 regarding the "new era" of home prices rising.

We'll begin first with a simple conversation on valuation. These experts say that stocks are cheap because their P/E ratios are at the historically low ends of their range. They say that using "projected future estimates" on earnings growth that the current P/E ratio for stocks is somewhere between 11 - 13.

These analysts take the current rise in earnings and draw a dotted line on a chart extrapolating that line directly upward at its current rate. This provides the P/E ratio today for the earnings projected in the future.

Let's use a chart of home prices to help explain how this works. The following shows Zillow's home price index rising and topping at the 2007 peak, the subsequent collapse, and then the start of the most recent rise. The chart has three projections: best case, most likely case, and worst case. All three expectations use a line that extrapolates upward moving forward based on the most recent 12 month period.

Your realtor sits down with you at your kitchen table and shows you these scenarios. The worst case scenario you are told is that your home only rises 11.7% by 2017. She is an expert and she has a chart, so you happily put down your deposit and move in.

Does this seem ridiculous? Of course it does, but this is exactly what happens every day when you call your financial advisor and he tells you stocks are cheap. Maybe he even takes the time to send you a chart of projected earnings rising upward forever.

Robert Shiller uses a P/E ratio that uses the trailing 12 months on earnings against stock prices today. It has no bias on where earnings may go in the future. Using that ratio the P/E is currently over 23, in the range where it has historically topped in previous bull markets.

The following chart shows this Shiller P/E ratio and notes that it is "well below 1999 peak" as if to describe the current ratio as cheap. It fails to note that is we are also at the range where markets topped in the early 1900's, 1937, and 1966. Only the late 1920's mania and the period we entered after Greenspan's famous 1996 "Irrational Exuberance" speech have seen higher P/E ratios.

Others will dismiss earnings and say that it is profits that count, and they are correct that companies have seen their profits surge during the post financial crisis recovery. Let's quickly review this important piece of the discussion.

The following chart shows the recent record breaking rise in corporate profits since 2009 (blue line). What the chart also shows and what many financial experts fail to mention is that corporate profits over time go through a mean reversion process. Coming out of a recession corporations slash costs significantly. The combination of lowering costs and rising prices causes the margins to rise. Over time they face trouble finding additional costs to cut as they may have already let go or cut the hours of every employee possible. Then they run into the normal business cycle down turn every 4 to 5 years where sales begin to slow their acceleration (this is happening right now).

This process has repeated throughout history and it will occur again. It is like the tides of the ocean. Most analysts today say that "this time is different" and in the new economy profit margins will continue higher forever.

Before I end the discussion it is important to briefly look at the other side of the equation when making an investment decision: Sentiment.

Why does sentiment matter? Because in the real world P/E ratios and profit margins do not decide when stock markets are going to top. Markets top when investors decide to buy less stocks than what is being sold, and not a moment sooner. In other words, a market can stay irrational for far longer than rational market observers would imagine.

Sentiment in the stock market today is beyond euphoric, and I have covered most of these sentiment indicators over the past few weeks as they have crossed over all time record bullish levels. Not post 2009 record bullish levels: all time historical record bullish levels. Greater than the both the 2000 and 2007 top.

During the week the market bottomed in March of 2009 the Wall Street Journal ran an article with the following headline:

"DOW 5000? There's A Case For It" From the article:

As earnings estimates are ratcheted down and hopes for a quick economic fix fade, the once-inconceivable notion of returning to Dow 5000 or S&P 500 at 500 looks a little less far-fetched.

Looking solely at valuations, namely price relative to earnings estimates, the S&P at 500 isn't necessarily a wild stretch.

According to Goldman's data, the bottom of the 1974 bear market had a forward P/E of 11.3. At the trough in 1982, it was 8.5. Put a multiple of 10 with estimates of $40 to $50 a share and the S&P comes out at 400 and 500.

Look at the chart from that article showing the "experts" predictions of earnings. They showed earnings plunging lower from that point in March of 2009. 

Contrast that to where we are today as earnings estimates show earnings surging higher from here.

What do articles look like today? This month saw the return of the author who wrote the now famous book "DOW 36,000" in 1999, just a few months before the market would peak and collapse (now famous because anyone taking his advice saw their portfolio destroyed). His views are now actually being published again in mainstream articles. Take a look at the following article and quote from Bloomberg this month:

"Market Record Shows How To Get DOW To 36000" From the article:

We wrote in the introduction that “it is impossible to predict how long it will take” to get to 36,000. Then, in the same paragraph, we rashly made a guess anyway: “between three and five years.”

Today, the far edge of that time frame is clearly in reach. From its low of 6,547 on March 9, 2009, the Dow has risen 117 percent. Another 117 percent in four years would put it at 31,022, just 16 percentage points shy of the magic number.

A market peaks when investors stop contributing new money to the asset, not when it becomes overvalued. I will not tell you that I am smart enough to know when that day will be or how overvalued the U.S. stock market will become before finally topping out. I can only show you that we have already crossed the point of danger based on historical valuations and sentiment levels.

For at long term at stock market cycles and the time frame I believe this bear market will end see:

Historical Guides: Stock Market Cycles & Public Ownership

h/t MarketWatch, Bloomberg, Zero Hedge, Zillow, Wall Street Journal