SEPTEMBER 08, 2010
In our first primer we discussed the notion of deflation and why a period of deflationary pressure is inevitable. We explained how inflation is created in our fractional reserve banking system via credit-based money creation by our banks. We also saw that when people stop taking out mortgages or home equity lines of credit and instead begin saving and paying off those debts, it shrinks the money supply and slows the velocity of money. This is what awaits us and this will exert tremendous pressures on asset prices, particularly leveraged assets like real estate and some stocks.
We then looked at whether or not there is a Canadian housing bubble in our second primer. I hope you now see that when you remove the anecdotes and clichés from the discussion and instead look at fundamentals, it is awfully hard NOT to see that house prices are significantly overvalued.
So today we turn our attention to a subject that is very dear to my heart: mass psychology. I want you to notice that in a normal, functioning economy, debt-based money should be created and destroyed at close to the same rate. Provided the population grows and GDP grows, there should be a slight upwards bias in money creation. So why have things gone so crazy in the past 10 years?
Let's look at some interesting data points. Many thanks to Jonathan Tongue for compiling these graphs.
Graph 1: Mortgage outstanding
Note the parabolic increase in mortgage debt outstanding since 1999.
Note that this is massively parabolic, approaching a near vertical move. This right here is the 'wealth effect' visualized. People have been more than happy to borrow against their home equity for many years now, as perpetually rising home prices have made them feel wealthier. Think about the implications for the broader economy. This consumer spending has fueled much of the growth we have experienced over the past 10 years. David Rosenberg recently calculated that every dollar of home price appreciation creates 9 cents in spin-off spending. It's not too hard to see that phenomenon in this graph. My position is that as house prices normalize, there will be a slowing and then a reversal in personal line of credit growth. This will choke off consumer spending. Hence, I see a recession in Canada by Q3 2011.
Graph 3: Credit card balance growth
Remember that debt constitutes a claim on future earnings, and therefore future consumption as it eventually must be repaid. This is why debt is inflationary in the short-term, but deflationary in the longer term, paradoxically. So back to the initial question. If debt-based money creation should roughly equally money destruction, why the massive boom in debt-based money creation over the past 10 years? This is the result of group-think. When everyone decides on mass that it makes sense to take on huge amounts of debt, while very few people save, a credit bubble is born.
To understand how this happened, let's rewind the clock back to the turn of the millennium where two significant events occurred. First was the crash of the dot-com bubble. Technology stocks reached massive overvaluation levels in late 1999. The tech-heavy NASDAQ index in the US was crushed in the following couple years, losing well over 80% of its value in one of the great bubbles of the past couple centuries.
People were burned by this massive bubble bursting. Consumer, who now felt poorer, began to retrench and the US was back in recession. Then came 9/11. This further damaged consumer psyche. In response to all this, the Federal Reserve in the US and the Bank of Canada both crashed interest rates to encourage consumer spending.
In response, consumers realized that their savings were earning them a pittance in their GICs and savings accounts. So the savings rate crumbled in both countries crumbled, with the US actually seeing negative savings rates for a short period of time.
Remember that as people save, the velocity of money decreases. Likewise, as they stop saving, leaving more money in the system to change hands, the velocity increases.
Now central banks can encourage spending, but they can't channel that spending. So, consumers who had been scarred by the stock market decided that real estate was the new safe bet, and the real estate boom began. It was the events of the early millennium set the stage for this new prevailing view of real estate to be born. As home prices began their ascent, more and more people piled in. Home ownership rates soared. Lax lending standards in both Canada and the US (the 'prudent Canadian banking system' fallacy will be addressed in a later post) led to a deluge of new buyers. Rising home prices then became the justification for rising home prices. Eventually everyone became convinced that real estate rises forever, it is a great investment (which it can be when the fundamentals are normalized), and everyone should own. That's where we find ourselves today.
Here is the connection to mass psychology: Any time people overwhelmingly believe that an asset is a 'sure thing' it inevitably has to be otherwise. It was John Kenneth Galbraith who astutely noted that, "In economics, the majority is always wrong". This is the great paradox in the world of finance and it is exactly why the contrarians always prosper.
To wit, consider the following article. The title is "Majority of Ontarians believe that real estate is a good investment". It goes on to indicate that 90% of Ontarians believe that real estate is a great buy and a solid investment. From other sources I have seen, this number is fairly consistent across all of Canada.
Faced with such an overwhelming majority who would disagree with me, I suppose I should probably recant the predictions made in my last primer and join the party. Well, I'm not quite there yet. In fact, this only strengthens my convictions that we are at the tail end of a bull market in real estate. Allow me to explain using a couple of wonderful graphs and a brief lesson in market psychology. One of the most amazing things about markets is that when a large majority of people believe that an investment is a sure thing, it invariably turns out to be otherwise. Cue the first graph. This one shows mutual fund manager cash positions in equity (stock market) mutual funds over time. It sounds intimidating, but it isn't. The bottom squiggly line indicates the portion of the fund that is in cash at a given time. The top line shows the stock market, in this case, the SP500 out of the US.
Why is this significant?
Well, a mutual fund manager will strategically move into cash (sell stocks) when they believe that the market will go down and there will be better buying opportunities in the future. Obviously. And when they believe that stocks will go higher, they reduce their cash position (buy stocks). What is absolutely astounding is that when taken on aggregate, mutual fund managers (who are supposed to be the smartest at picking stocks) are always holding their highest cash positions at times when the markets are about to take off, and always have the lowest cash positions at times when the market is about to tank. In other words, they have it dead wrong virtually 100% of the time. Seriously! The vertical dashed lines make the connections for you. You see that the bottom line (cash position) is always spiked higher at times that correspond with an uptick in the top line (stock market) and vice versa.
This is a very well-studied phenomenon. For a great perspective on this as it relates to stock markets, I would suggest you read the following two books: A Random Walk Down Wall Street by Burton Malkiel, and The Little Book of Common Sense Investing by John Bogle. Both are fantastic. The two points that must be gleaned from this are as follows:
1) Mutual fund managers aren't worth the money you pay them. You get much better value and much better long-term performance by buying an index fund.
2) As it relates to all markets, including real estate, anytime that the majority is convinced that the market is a sure thing, it will invariably do the opposite, as the majority of the money has already positioned itself accordingly. In this case, if everyone has sold to build up their cash position, no one is left to sell. That means that buying will dominate, and prices will move higher by necessity. The opposite is also true, and now is the time to make the connection with real estate. If everyone has bought expecting a higher price, then the majority of the money is already in play on the buy side, leaving the sell side to dominate the foreseeable future, with lower prices being the result of the immutable law of supply and demand.
One more graph will further illustrate the amazing effect of market psychology. This one is kind of like the inverse of the last graph. Essentially what it shows is the stock market on the bottom (SP500 out of the US) and at the top is the percentage of stocks that are rated a ‘buy’ by analysts. This index is known as the Bullish Percent Index or BPI.
Once again, the line at the top indicates the percentage of stocks in the SP500 that are rated as ‘buys’ by analysts. Clearly thee analysts believe these stocks will be going up. What you will notice is that, as with the last graph, points of maximum pessimism are inevitably linked to points at which the stock market is about to break out to the upside, while points of maximum optimism are always associated with periods of heightened volatility and times of downward pressure on stock prices. Amazing isn't it?
In any market, overwhelming majorities always indicate that the opposite is about to happen, as the overwhelming majority has positioned itself (themselves?) to prosper from the 'obvious' coming increase in asset prices. With real estate, 90% of the population currently believes that it is a good investment (the highest in 12 years). This has translated into higher ownership rates (the highest in several generations). So the question must be asked, 'if so many people have positioned themselves to prosper, to whom will they sell to to realize their gains'? And that, my friends is why I am soooooooo unimpressed when I hear the talk about the massive abundance of real estate bulls out there.
You should not be swayed either. The contrarians always prosper, as evidenced by the above two graphs, as well as countless academic studies on market psychology. Public opinion will inevitably shift back to a dislike of real estate as an asset class. It will be then that I, and the other smart money, will make a move. I would advise you who may be considering a purchase to do likewise.
I have long believed that the government interventions back in the Fall of 2008 did nothing to alter fundamentals. Rather, they dragged demand forward and exhausted the pool of potential buyers. There is now a void in potential buyers at the same time that people try to cash in on their real estate equity en mass. Hopefully you heeded the advice not to follow the herd!
I'll leave it for you to decide where we are on the bubble progression.
Cheers and blessings,