In a WSJ article last week Gary Shilling and Eric Lascelles answered an important question: “Is now the time to buy your first house?”    Shilling argued that inventories were still too high and would put downward pressure on real estate prices likely resulting in a further 20% decline in national prices.  This is consistent with the historical average as seen in Robert Shiller’s inflation adjusted house price index.  Lascelles, on the other hand, argued that housing was very affordable based on several affordability metrics and that purchasing a home in this environment will prove a steal.

My opinion sort of agrees with both men.  Now, I’ve been a big bear on real estate for a long time now.   I used to get in blow out arguments with my mother over the price of real estate back in 2005 and 2006.  In a 2006 client letter I said:

“The credit driven housing bubble remains the greatest risk to the equity markets at this time.”

In early 2010 I said prices would likely decline another 7-15%:

“As I said above, the most likely scenario is the “work-out”.   Government stimulus continues to bolster the private sector in the back half of 2010, but the lack of direct aid in housing begins to weigh on the housing market in the second half of 2010.  Negative seasonal trends make for a very difficult H2 in housing and a tough start in 2011.  The economy appears fairly strong into the latter portion of 2010, but the dwindling stimulus ultimately pressures the private sector.  Demand for housing remains tepid as job growth is weak, the unemployment rate remains above 8% into 2011 and the negative inventory trends prove too much for the real estate market to overcome.  Ultimately, prices decline 7%-15% over the course of the coming 2.5 years.”

Prices are down exactly 7% since then so it’s time for an update.  While I am not a raging bull on housing I am also no longer a raging bear.  I am rather neutral now.

First, I think Shilling is potentially right to a certain degree.  There probably is more downside in some real estate markets.   But I don’t think there’s 20% more downside in national prices.  Instead, I think we’re likely to muddle through from here with a classic post-bubble “work out” period.  I recently described why I think this is likely:

“If we take a step back and look at some longer-term data we can put this in perspective though.  I like using the Shiller CPI adjusted housing price data as well as the owner equivalent rent data from the monthly CPI reports.  These two charts will help put the declines in perspective.   As you can see below we’ve made significant progress in the mean reversion process.  According to both indicators housing prices are overpriced by roughly 15%.  This likely means there is more downside risk in the coming years, but the bulk of the declines are definitely behind us.

I think the more likely scenario is the standard post-bubble work out period where prices will not “bottom” (as many have called for), but will rather flat-line for many years.  Pull up a chart of the Nasdaq or Nikkei or Shanghai or any other number of bubbles if you’re trying to imagine what I am referring to.  What would be HIGHLY unusual is for prices to snap-back or “bottom” in a dramatic event process that leads to a surge.  Rather, we’re far more likely to see the high inventories work off slowly while prices moderate and incomes grow to bring the market back to some semblance of normalcy.”

So my guess is Shilling’s prediction for 20% downside and a possible overshoot further is extreme.  As Lascelles argued prices have become much more affordable in many areas, inventories are coming way down and the price to rent is back to very reasonable levels.  Calculated Risk has some update charts here:

(Price to rent)

(Existing home inventory)

All of this adds up to one thing.  Real estate is far more attractive than it was at any point in the last 8 years or so.  Has it bottomed?  That’s the wrong question in my opinion.  Real estate likely won’t crater from here, but also won’t skyrocket.  ”Bottoms” (as in an event bottom) are very unusual after a bubble like we’ve seen.  The standard post-bubble “work out” period is the most likely scenario so prices could be flattish for years.  So do you buy now, rent, invest?  First, I don’t think the average retail investor should bother with investing in real estate.  Real estate investing is a full-time job and requires a great deal of hands on involvement to actually turn a consistent profit above the rate of inflation over any sustained period.  When you buy a house you should think of it as a roof over your head and a place where you will LIVE.  Not an investment.  And this is the key.  If you’re planning on living in a house (as in, 10 years of actually living in a home) then you should have no great fears about buying today.  Does that mean you’ll make money on it?  Or that it will prove more beneficial than renting?  Well, that depends on a lot of personal variables.  But the base case here for national real estate is that the risk/reward of buying a home has changed substantially and is no longer skewed to the bear case.

]]> http://pragcap.com/is-now-the-time-to-buy-a-house/feed 46 http://pragcap.com/3-signs-japans-de-leveraging-cycle-is-ending http://pragcap.com/3-signs-japans-de-leveraging-cycle-is-ending#comments Wed, 16 May 2012 05:25:14 +0000 Cullen Roche http://pragcap.com/?p=44659 Credit Suisse has published a nice note on the balance sheet recession and Japan’s de-leveraging cycle.  Japan has undergone one of the most crushing de-leveraging cycles in history due to simultaneous asset bubbles in equities and real estate and an extremely misguided policy response.  The result has been a 20 year malaise that has knocked the Japanese economy down to the world’s fourth largest.   The good news according to Credit Suisse is that the balance sheet recession in Japan is finally ending:

“Unlike the US, UK or Eurozone, Japan’s corporate sector over the last 20 years faced a daunting prospect of having to de-leverage against the backdrop of deflation and flat nominal GDP. In our view, the Japanese corporates have performed a near “miracle” of reducing US$6 tn of debt without help from growing economy and despite the reluctance of BoJ to embrace a more aggressive monetary policy. It seems there is growing evidence that after 20 years, the Japanese corporate sector is finally “healing”. We focus on three signs: (1) the corporate sector is no longer reducing debts or increasing cash; (2) private investment is no longer declining; and (3) ROE and ROIC are gradually recovering (though from depressed levels). At the same time, Japan’s labour productivity growth rates continue to offset the poor demographics, while competitiveness, innovation and complexity indices remain strong. It seems likely that the corporate sector could surprise on the upside.”

Source: Credit Suisse

“The head of Greece’s Radical Left Coalition, Alexi Tsipras, told CNBC Thursday that he will “go as far as I can” to keep Greece in the euro zone despite declaring earlier this week that the Greek bailout agreement is “null and void” and should be abandoned.”

It’s about time that someone step up to the Germans and start pushing back.  For years now, I’ve been trying to explain why Germany is NOT in the driver’s seat.  Why you ask?  It’s simple.  So, they’re all involved in a single currency.  So there’s no floating exchange rates to balance trade.  There’s also no currency sovereignty so each of the nations are susceptible to solvency crisis.  So what happened was the trade deficit nations inevitably had to borrow from the trade surplus nations to fund their continued spending.  Who was doing most of this lending?  Germany’s banking sector of course.  So, the two are inextricably linked.  If Italy, for instance, defaults, it will kill the German banks.  Additionally, because Germany is the primary trade surplus nation in the region they are enjoying the benefits of the single currency system.  If Italy were to bring back the Lira in this environment the Euro would soar against the Lira making Germany less competitive with Italy.  So, Germany has A LOT to lose here.  In fact, I’d argue that it’s the periphery holding all the cards here.

This should have happened years ago, but it’s about time someone like Tsipras steps up to the plate.  He should not even bluff with Merkel and the Germans.  He should walk right up to the Germans and tell them how it is: “we are going to blow this whole thing up if you don’t start giving us what we want”.  Then the ball’s in Germany’s court.  Maybe they leave the Euro?  Maybe they succumb to the pressure and move towards something resembling a fiscal union?  Maybe they give in on E-bonds?  Who knows.  But someone needs to push back because the current construct isn’t working and isn’t going to work.

There has been lots of talk from both sides about who is right and who is wrong.   And while the hyperinflationists have been dead wrong for 4 years now, they’re relentless in claiming that it’s still coming.  Well, my friend and fellow MMRist Mike Sankowski is finally putting this bet into writing.   He says:

“If you haven’t dug into the comments section over the last month or so, team MMR is having a long standing debate with vincent about hyperinflation.

I don’t think there is any chance of hyperinflation. So I decided to go on the record, with a public statement about hyperinflation. 

Longbets.org is a great site, and it’s part of the long now foundation. The Long Now foundation is creating this very cool clock which will keep time for 10,000 years. Very cool. I saw Eno and Hillis in London at a discussion on the long now, and that was fantastic.

Here is a link to the prediction: Inflation prediction

The prediction is being reviewed by the long bets staff as of 8:15am Chicago time on 4-25-2012.

vincent is sharp, and so far the discussion has been polite. We’d like to keep it that way!”

So there it is.  This one will no doubt get rubbed in someone’s face at some point in the next few years so it should be fun to watch.  And if the hyperinflationists win, well, I plan on being the first inhabitant of Crusoe Island where the USD is not the currency of choice.  :-)

“Even the prospect of unsustainable deficits has costs, including an increased possibility of a sudden fiscal crisis. As we have seen in a number of countries recently, interest rates can soar quickly if investors lose confidence in the ability of a government to manage its fiscal policy. Although historical experience and economic theory do not indicate the exact threshold at which the perceived risks associated with the U.S. public debt would increase markedly, we can be sure that, without corrective action, our fiscal trajectory will move the nation ever closer to that point.”

There’s little doubt in my mind that Dr. Bernanke is a genius.  But it confounds me how he has not connected the dots on a few things.  As the man in control at the Fed he should know that the Fed is the supplier of reserves to the banking system.  This is not a small power to harness.  It is a colossal power.   But Dr. Bernanke does not understand the depth of his own powers.

You see, as the supplier of reserves the Fed can control the yield curve.  That’s right.  There are no bond vigilantes in the USA.  There is no time when the Fed has to buckle to the demands of the bond markets.  If the Fed wants to set rates across the entire curve they will simply say so.  They could buy back every outstanding bond there is at a specific rate of 0%.  This would essentially flatten the curve.  You could bet against the Fed’s actions, but as the supplier of reserves the Fed will never lose this fight to a bunch of arrogant Wall Streeters.  After all, the bankers are currency users.  The Fed is part of the currency issuer.

Now, some will say that the Fed will have to raise rates when we become insolvent or when inflation surges.  This is true, but only to a certain degree.  An autonomous currency issuer like the USA cannot “run out” of money.  The USA has a printing press.  As long as our debts are denominated in the currency we can print at will it is silly to worry about us defaulting on our debts (assuming our politicians don’t choose to default!).  Dr. Bernanke alludes to Europe in this case, but the European nations are all currency users.  They do not create the currency their debts are denominated in.  So his analogy displays a clear misunderstanding).

But what about inflation?  Yes, it will rise one day.  But the most likely cause of rising inflation will be surging oil prices via a supply shock (which will likely cause recession when the price shock hits consumer wallets) or will arise from the fact that consumers have spending power and the economy is booming again (a problem Dr. Bernanke would love to have right now).  So yes, inflation is always our concern.  And if inflation surges due to a strong economy the Fed will be right in raising rates.

So yes, be very afraid.   But not because of bond vigilantes.  But because the wizard doesn’t fully understand the machine he’s in control of.

Dunce Cap:  ”Can you give some background and description on how you use/view rail traffic data including how (and how well) it works as an macro-econ. indicator?”

CR:  I use rail traffic as one of MANY macro indicators.  I build it into some of my models and various indicators, but it’s just one of many different indicators that we should look at.  Historically, it has been a very good leading indicator and one of the few weekly indicators of economic growth that investors can use as a fairly real-time gauge of the economy.  But while it’s very useful in gauging broader perspective I would never lean on it by itself.

Bernard:  I read your blog every day, have followed links to past seminal articles you have written, but have not seen anything from you that acknowledges the U6 unemployment rate(taking into account those no longer looking for work after four weeks and the under-employed).

CR:  I do track the U6 unemployment, but I guess I just never really found it to be much more informative than the standard unemployment rate data.  For instance, the correlation between the two is extremely high.  So while it’s important it just doesn’t tell us a whole lot more than the standard unemployment rate used by the mainstream.

WOJ:  Spain clearly seems to pose a large forthcoming issue for the EU/ECB. Spanish banks hold untold losses in housing related assets and are now sitting on further losses from the recent LTRO-induced purchase of Spanish sovereign debt. What are the odds that Spain is forced to withdraw from public debt markets in the next 6 months and receive a bailout from the EU/IMF? If this happens, how quickly will the situation deteriorate in bond markets for Italy and in providing support for the remaining core countries facing increasing bailout burdens? Lastly, do you foresee further attempts at QE, via LTRO, or direct purchase of sovereign debt by the ECB to be the next step?

CR:  I really think Europe will continue to hold the line in bailing everyone out as necessary.  There’s certainly some chance that the smaller nations could defect and default, but that won’t happen unless civil unrest becomes a problem similar to the Arab Spring and forces real change from within.  For now, the European establishment wants to hold Europe together.  So it’s all about whether the ECB will continue to write checks until they get some sort of permanent fix in place (a central treasury of some sort).

dijssel5: You mentioned about an increase in the risk for recession due to a decline in deficit spending or a “fiscal cliff” in 2013. Don’t you think that when faced with a slowing economy, the government will extend the Bush tax cuts, payroll tax cuts, unemployment benefits?

There’s a viral video going around by Tony Robbins on the national debt.  Unfortunately, he makes the dreaded error of confusing a currency issuer with a currency user.  Of course, the two can never be compared since a currency issuer has no solvency constraint meaning that they can never “run out of” currency like currency users can.  So the national debt and having to “pay it back” is never a concern.  Rather, the concern is always inflation which is a very very different phenomenon than being unable to make payments.   See the following video for more and if you’d like to review inflation and the true constraint for a currency issuer then please see the other video attached below. And if your interest is really piqued or you’re really confused you might want to spend a few hours on my paper about the monetary system which can be found here and contains much more detail.

Oh, and if you know Tony Robbins get this to him….

Video on inflation and explaining the true constraint:

Just to be clear – QE in the USA does not work by “funding” the spending of the US government.  I know this is a rather unorthodox perspective, but the government doesn’t need to buy its own bonds in order to print money that it can print at will.  Remember, bond auctions are not funding operations.  They are reserve drains.    You might see here if this is already confusing you.

The keys to understanding QE is in the following points:

• Because the USA is sovereign in the US Dollar, there is no such thing as “funding” the spending of the government.  Therefore, there is no such thing as the Federal Reserve being able to “fund” the US Treasury.  See this article for more.
• QE in Europe can actually “work” because it is essentially a form of fiscal policy that actually helps to fund the countries in Europe (or at least help them avoid losing funding).  This would be like the Federal Reserve buying municipal bonds from states in distress who can’t find Federal funding (this would essentially be a form of fiscal policy and would be “money printing”).
• QE in the form of buying back government debt is not “money printing” or “monetizing the debt”.  It is a swap or a change in the composition of private sector financial assets.  No net new financial assets are being added.  The private sector gets reserves, the Fed takes the bonds.  The net loss is in the difference in interest income.  But the private sector is not left with “more money”.
• Banks never lend reserves so more reserves don’t mean more lending.  Loans create deposits.  The money multiplier is a myth.  This is why QE1 and QE2 did not cause a surge in loans or inflation.
• The wealth effect in equities is a myth.  The flaw in QE is that it reduces the number of specific securities so it can force investors out of one asset and into another.  This can drive up prices, but does not necessarily drive up the fundamentals.  It’s not unlike a stock buyback and its immediate effects which drive up price, but have no impact on the underlying corporation.
• The portfolio rebalancing effect of QE can cause substantial disequilibrium in the economy.  We saw this in QE2 when I repeatedly predicted that QE was causing an imbalance in bond and commodity prices.  And when the air came out of that 2010 nearly turned into a nightmare….

If you still have questions on QE I would consult this more detailed primer.

• Is there a bond bubble?
• Is the Fed becoming irrelevant?
• Is the USA losing its reserve status and will this crash the dollar?
• What is the LTRO and has it worked in Europe?
• Why the Euro crisis is not over.
• Is the stock market “cheap”?
• Why I hate PE ratios.
• Why the boom/bust cycle is here to stay.

Listen to the full interview here.

1.  Bonds are in a bubble

DR:  No, bonds are not in a bubble.

CR:  No, bonds are not in a bubble.   I outlined my position on this in some detail several years ago, but in short – I think the term “bubble” is being abused in reference to bonds.  Bonds are a fixed income product, which if held to maturity will return 100 cents on the dollar plus interest.  Can you get left holding the bag if you trade bonds?  Yes.  I’ve pointed out two different occasions over the last 3 years in which bonds were particularly risky – January of 2010 and January of 2012.  Both events were followed by substantial declines in bond prices, but not the end of the secular bond bull.    But the bigger point here is to understand what it would mean for bonds to be in a bubble.  A bubble implies risk of catastrophic loss.

But let’s remember a few things – first of all, if you ladder into a bond portfolio and actually diversify across bonds then you can substantially eliminate this risk.  But more importantly, you must understand the potential macro drivers of a bond market collapse.  First, the US govt bond market is not susceptible to Greek-like raids by mythical bond vigilantes (see here for more).  Second, since inflation and not solvency is the concern for an autonomous currency issuer, then we need to always worry about inflation, right?   What are the big inflation risks, right now?  Most likely a supply side oil shock generating a 1970′s style environment (which would likely be followed promptly by a recession) or an economic boom.   If we’re in for an economic boom (which will likely lead to higher wages, higher prices, etc) then you better also be diversified across other asset classes because bonds should never be your entire portfolio.  Bonds serve a specific role in a portfolio – to help hedge and diversify other holdings.  If you’re properly diversified then bond declines (even substantial bonds declines) will be more than offset by gains in other assets.

2.  The LTRO saved Europe

DR:  The LTRO kicked the can.

CR:  The LTRO kicked the can really hard.

I’ve laid out my opinion on Europe previously, but it might help to refresh.  The problem in Europe is simple.  Because none of the countries are autonomous currency issuers they all suffer from solvency constraints.  They can’t print Euro without the approval of a foreign central bank in essence.  So, unlike the USA, they can “run out of money”.   This makes for frightened bond investors.  The problems all arise out of the trade imbalance which essentially forces the core to lend to the periphery to maintain growth.  This is only sustainable up to a point and that point has been reached.  So the issue now is that you must fix the broken currency.  You must make these nations autonomous in their currency.  The only two ways to do that is to create some sort of US of Europe.  Or default, defect and bring back the old currencies.  So far they’re trying to keep the ship from sinking, but the water is pouring in faster than it’s getting bailed out (pun very much intended).  The LTRO was a powerful tool that helps prolong this process.  It’s really just more of the same ponzi backed by the ECB.  The private sector lends to the periphery and on we go.  It won’t work.  They need to do more…..

3.  The US fiscal situation is intractable

DR: Washington must tackle the fiscal problem before it gets out of hand.

CR:  I had to look up the word “intractable” so let me just start by stating that I feel pretty stupid already.  But DR misses the point here.  The USA is an autonomous currency issuer.  There is no such thing as our financial situation leading to insolvency.  The US government is nothing like a household.  It cannot “run out of money”.  Nor is it like Greece or Spain or Portugal or any of the countries in Europe involved in that mess of a single currency.  Remember, the states in the USA are analogous to the countries in Europe – not the US federal government.

So what is sustainable?  Well, as mentioned briefly above – we are constrained by inflation.  We could spend so much money into the economy that it causes massive inflation and destroys our living standards.  I have long argued that inflation and hyperinflation fears are overdone for various reasons (misunderstanding monetary ops primarily).  But the bigger point to understand here is that the USA doesn’t have a solvency constraint like you or I do.  The nation has an inflation constraint.  It’s not a semantic difference.  See here for more.

4.  It’s clear sailing ahead

DR:  No, the economy is still very weak

CR:  I’ve been much more optimistic than most others about the economy.  I was very vocal last year that I thought there would be no recession and once again believed this to be the case in 2012.  But the risks are looming large.  The balance sheet recession is waning, but it’s not over.  The government has propped up the economy through large budget deficits that helped offset the de-leveraging process.  There are signs of healing, but we must not rip the band-aid off.  The private sector is still not quite ready to run with the baton.  See my full view here.

5.  Housing is embarking on a full fledged recovery

DR:  No, housing remains and will remain very weak.

CR:  As I detailed yesterday, I think the housing market is stabilizing, but I think “bottom” calls are misguided.  There will be no event-like bottom in housing.  Instead, I think housing will likely flat-line for years.  We could see good years and bad years, but I think we’re in the beginning to middle stages of a typical post-bubble workout period.  Bubbles rarely bottom and bounce back to highs.  Rather, the extremes from the previous cycle get worked off over long periods of time.  In this case the high inventories and slowly recovering consumer balance sheets will come together to create a rather mundane housing environment for the next 5 years or so.

6.  No hard landing in China

DR: There are enormous downside risks in China

CR:  China is a black box.  I’d have more luck guessing the velocity and vector of Haley’s Comet at this instant.  But yes, I agree that there are enormous risks involved in a country which builds empty cities in the desert and routinely releases economic data that is filled with holes….In short, I just don’t know enough about China to know what’s really going on there.  And I would be shocked if anyone outside of their government really knows either….

7.  The surge in gas prices doesn’t matter

DR:  Gas prices will eat into consumer spending.

CR:  Gas prices will eat into consumer spending.  We seem to have this debate every year now.  And every year people say the same things.  The same analysts find a new excuse for why it’s different this time and their opponents say it will cause a slow-down mid year.  And we tend to see a slow-down mid year.  I see no reason why this year will be different.  Goldman’s Jan Hatzius doesn’t disagree.  But the more interesting effect might just be abroad where gas prices are ripping the hearts out of already suffering European economies.  You think gas prices are high here?  Whew.  Go over to Europe and fill up….Now that’s pain at the pump.

8.  Inflation is coming back

DR:  Inflation is the last thing to worry about

CR:  I am a bit more concerned about inflation than DR is.  But only moderately so.  I’ve been pretty consistent over the years that I am not worried about high inflation, but we are now beginning to see real signs of economic recovery and sustainable credit growth.  This could all be a recipe for a sustained fight with inflation.  Of course, the government could torpedo all of this might cutting the budget deficit massively, but we’ll play that by ear as the year plays out.  I still think there’s upside risk in inflation data from here, but I’d be shocked to see high single digit inflation any time soon.  It’s not the last thing to worry about, but I generally agree with DR that the risks are overstated here.  We need to worry about getting back to full employment and full capacity first….Having an energy plan of some sort would also help.

9.  The stock market is cheap

DR:  The equity market is not cheap.

CR:  I wouldn’t put all your eggs in the valuation metric basket.   Most valuation metrics are relatively misleading except at market extremes.   Most of them are rear view mirror looking or based on guesses by analysts who have no idea what the future actually holds.