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Housing Market Perspectives (26 September 2008)

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During the last month, a number of phenomena became apparent which I would like to highlight in order to assist you in your decision making. Market action has made it clear that times are changing and we need to start adjusting our perceptions in order to improve the accuracy of our outlook and the quality of our financial decisions.

Section Index

Perspective 1 – House Prices Will Fall More Than You Think>
Perspective 2 – Don’t Hold on as House Prices Fall >
Perspective 3 – The Early Bird Doesn't Catch the Worm >
What To Do? >

Perspective 1 – House Prices Will Fall More Than You Think

One of the observations I note in the “Amplified Market Cycles” section of “The Essentials” is that the market cycles we have experienced over the last 30 years have been more amplified than one would normally expect. We have seen periods of outstanding expansion, followed by painful, exaggerated contractions. The example I use is of the dramatic rise of the global stock markets during the 1990’s and subsequent catastrophic collapse when the bubble burst in March 2000.

S&P500 and Nasdaq Corrections

This phenomenon is the result of the exponential increase in the supply of money, which led to the exponential increase in credit creation. As the massive influx of paper money entered banking systems around the world, banks were able to lend it with increasing ease. The easy money was used to fund purchases and investments, enabling economies around the world to expand at an unsustainable rate.

These exaggerated booms are great while they last, but eventually the tide turns to expose years of excess and a lack of risk control. Steep, painful contractions result as the excesses of the boom are unwound, revealing the latest example in a series of amplified cycles which have occurred since the end of the Bretton Woods agreement.

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” Ludwig von Mises.

Pick a Number, Any Number

If you ask an average homeowner how much they think house prices will crash under a worst-case scenario, they tend to say 30%. If you ask the average equity investor how much the stock market will crash, they also tend to say 30%. If you were then to ask these people why they thought prices would crash 30%, no explanation would be forthcoming.

I have had many conversations with acquaintances recently in which I explain my background and my outlook for significant falls across most markets over the medium term, and I continue to be faced with the same response: “I don’t think prices will fall that much, a fall of 30% seems more realistic.” When I press further and enquire why they think 30% is realistic, the majority of the responses are also the same: “30% seems reasonable”, or “I just can’t see prices falling more that 30%”.

I guess that 30% sounds like a comfortable crash. It’s an acceptable fall, painful enough to feel like a proper crash but not devastating enough to make a quick recovery seem unrealistic. This is a fascinating trick of the human psyche.

I base my price expectations on facts, whether it be the level of interest rates, the availability of funding, the return an investor would expect to make etc. A range of such factors form the bedrock of the targets I set out in my outlook. I also have a gut feeling for the direction of the market and the size of the correction based on years of experience participating in the financial markets. It was my gut feel that alerted me to the fact that house prices seemed to be rising too steeply, long before I actually sat down and crunched the numbers.

The Current Market is Very, Very Volatile

The developments over the last month demonstrate a new era of exaggerated volatility, culminating in a crazy week ending September 19th.

Stock Market

Following news of the Lehman Brothers bankruptcy the Dow Jones Industrial Average tumbled 504 points, its worst point drop since the Sept.11 attacks. Later in the week the Dow slumped to its lowest level since October 2005 as lending between banks around the globe nearly ground to a halt. However, news of the US government plan plan to take over debt instruments linked to bad home loans allowed the Dow industrials to forge their biggest two-day gain since March 2000. Trading volumes for all shares traded on the New York Stock Exchange by the NYSE Group spiked to 4.2 billion on Thursday 18th, the highest level on record.

Oil Market

After falling almost 40% from their peak, crude oil futures hit a low of $90.80 per barrel last week, the lowest level since early February. They then spiked back up over $100 for their biggest one day gain ever.

Gold Market

On Wednesday September 17th gold jumped more than $70 an ounce on the New York Mercantile Exchange, its biggest one-day jump in dollar terms since at least 1980. On Friday however, the precious metal then tumbled by more than $68, its biggest drop in 28 years.

Bond Market

On Monday September 15th the yield on two-year US Treasury notes slumped the most since the Sept.11 attacks, before jumping by the most in more than 20 years on Friday 19th.

My Recommendation - Update Your Perception of Volatility

Don’t fall into the trap of basing your outlook on what seems normal, or on what happened during the last house price or stock market crash. 30% may seem like a normal, acceptable crash but these are not normal times. The banking system is collapsing with most financial institutions heading towards insolvency. Just because Lloyds and HBOS have recently merged does not mean that the enlarged bank will manage to survive. We are only 25-30% way through this crisis and have yet to see the final capitulation stage, which will swallow up many more household names.

Over the next few years you will need to be more prudent in your analysis and more cautious in your outlook. The paradigm we currently know and accept is changing and we need to adjust our perceptions as a result. A few years from now, once the dust has settled, we will look out on an unrecognisable financial landscape in which debt is despised and saving is an integral part of life. Many will lose the majority of their wealth – don’t be one of them.

For anyone interested in reading more about this paradigm shift I recommend George Soros' new book “The New Paradigm For Financial Markets – The Credit Crisis Of 2008 And What It Means”.

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Perspective 2 – Don’t Hold on as House Prices Fall

There is a great illustration of human behaviour given in one of Jack Schwager’s Market Wizards books. He interviews one of the world’s top traders who recounts a tale about a farmer trapping game birds. The trader then compares the farmer’s thought process to that of an amateur investor holding on to a falling investment for too long.

The reason I use this example is that I currently see parallels between that farmer and homeowners who continue to see the value of their homes decline, yet refuse to cut the price or instead decide to rent out their properties and to wait for a recovery in prices.

The Tale

A farmer sets out to trap game birds on his farm in order to sell them at market and make a profit. In a small clearing he sets up a cage and baits it with bird seed. Now hidden from view, the farmer observes 15 birds in the vicinity of the cage.

12 birds
Lured by the seed, within a few minutes 12 of the birds wonder into the cage. The farmer, pleased with the results is about to pull the release chord which closes the trap when another bird starts heading towards the cage. Keen to make the extra profit at market, the farmer waits.

11 birds
Unfortunately, the thirteenth bird changes direction and strays away from the cage. Simultaneously one of the birds already in the cage walks out. The farmer, having previously trapped 12 birds, is now disappointed with the loss 1 and decides to wait a little longer in the hope that one of the birds will stray back in.

9 birds
To his dismay, another 2 birds leave the cage, leaving him with 9. The farmer is furious and tells himself that he should have just closed the cage when he had 12 birds. Not happy with a bounty of only 9, he decides to wait longer still, again hoping that some of the other birds will wonder back into the cage.

7 birds
Another 2 birds leave the cage, taking the number down to 7. The farmer is livid. He reasons that, having lost 5 birds from the cage, it is no longer acceptable to close the trap and cut his losses, but decides that he would be happy to accept a harvest of 10 birds. Having set his goal, the farmer waits for 3 birds to re-enter the cage.

3 birds
Another 4 birds leave the cage. In sheer frustration, the farmer pulls the chord, trapping the 3 birds still in the cage while scaring the other birds away. The farmer can now sell 3 birds for profit at the market, but struggles to come to terms with the loss of a theoretical 9 birds. If only he hadn’t been so greedy, he could have made a much bigger profit.

The Lesson

This is classic investor psychology and I see it time and time again in the current housing market. I have seen people put their houses up for sale only to be disappointed with the offers they receive. As a result they take their houses off the market or decide to rent them out instead.

Taking my own recent experience as an example, a few years ago my wife and I signed a rental agreement on a lovely character cottage, in a small village with great links into London. Our landlord had been trying to sell the property for some time but had received no serious offers, probably because he was asking for too much money. In sheer frustration he decided to rent out the property instead, becoming an involuntary landlord. Most involuntary landlords don’t think like business people, they tend to retain a strong emotional attachment to the property, which frequently causes friction between themselves and the tenant.

At the end of the second year of the tenancy, the landlord decided that he was going to put the property back up for sale. We didn’t want to buy it, obviously, and so moved out in March of this year and are currently renting another great house, again in a small village with excellent links into London. I have been keeping a keen eye on the original property ever since, and was amused to see that today it remains unsold and funnily enough has just gone back on the rental market. In the last 6 months the value of the house has gone down about 10% and the landlord has lost 6 months of rental income. Not such a smart cookie!

The reality of the matter is that many sellers cannot get the sale price they want because house prices have fallen. And with banking failures and massive bailouts shaking the markets, the outlook is for even lower prices in the years ahead, not higher ones.

I fear that, as house prices continue to fall, the majority of sellers will inadvertently lose a significant proportion of their wealth while attempting to extract an extra few thousand pounds from buyers at the top of a hyper-inflated housing market. Don’t fall into the same trap.

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Perspective 3 – The Early Bird Doesn't Catch the Worm

After all these years in the markets, one of the things which still amazes me is the propensity of market commentators and participants to pick the bottom of the market incorrectly and frequently (or the top of the market for that matter).

It is not the fact that they do not call the exact bottom which amazes me, after all, no one can. It is that they continue to call the bottom incorrectly all the way down.

It is clear that most commentators base their proclamations on their own desire to see house prices or stock prices stop falling. This makes sense, they have investments and pensions like the rest of us. And we all want our wealth to increase, so there is an inclination at every juncture to exclaim the bottom is here, and that it is back to business as usual – rising prices.

This is the Bottom! No here! Hold on…

The current trend seems to be that every piece of bad news is labelled the turning point:

> Fannie and Freddie are bailed out – big sigh of relief – stocks must go up from here;
> Oil falls in price – the commodity bubble is over – long live stocks;
> Lehman Brothers goes bankrupt – wow, things are bad! So bad that this must be the bottom;
> Merrill Lynch bought by Bank of America – a luck escape for Merrill, only positive news ahead;
> AIG bailed out – another sigh of relief, now it must really be the bottom;
> Morgan Stanley and Goldman convert to banks – federal oversight brings stability!
> Short selling restricted – great, buy buy buy;
> Warren Buffett invests $5bn in Goldman – if Warren’s buying it must be a bottom; and so on…

We have seen that every announcement brings jubilation that the bottom has been reached. The market rallies and for a short while it looks like we are on the road back to the good old days.

This is natural since the average person wants the turmoil to be over. They are used to an environment in which house prices and investment values rise. Thus at every bailout or bankruptcy they declare that the turmoil is over because that is what they want. But as Warren Buffett says, Mr Market doesn’t care what you want.

The Bear Lives On

In every instance, clear confirmation that we are still in a bear market comes when temporary relief rallies in house prices or stock markets give way to new waves of selling and new lows are reached. We will only have found the bottom when no new lows are made, and that is some time away. I keep hearing that it is always darkest before the dawn, but it is also darkest just before pitch black.

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What To Do?

As I mentioned earlier, we are only 25-30% of the way through this period of turmoil. There is an awfully long way to go and house prices and stocks will continue to fall over the medium term. As we also saw earlier, these markets are extremely volatile, so investment timing becomes difficult. I am selecting the investments which I believe will do well over the longer term, namely commodities, and I am building my positions gradually over time. My view is that commodities will do extremely well in the inflationary environment which lay ahead.

Due to the astonishing levels of debt built up over the last 30 years or so, the governments of the developed world will have no choice but to inflate their way out of this crisis – that is, print huge amounts of paper money which causes the value of their currencies to fall and makes debt easier to pay back.

For example, if I take out a £100k mortgage today, and tomorrow the government runs the printing presses full steam and massively expands the amount of paper money in circulation, the value of the pound will fall. As the money in my bank account and wallet falls in value the price of real assets will appear to rise, which is what we have seen happening to gold, oil, wheat, rice, corn, sugar etc, etc.

As the cost of living increases, it prompts me to negotiate a higher salary with my boss. Under these circumstances the average wage of £25k may rise to say £50k per annum. In real terms I am paid the same as I was before the printing presses were turned on, but since the value of each pound has decreased I need to receive more of them to compensate for the fall in value. However, while my salary, gold, oil, food etc have increased in value, the debt I owe has remained the same - £100k. Thus, by printing money the government has made it easier for me to pay back my mortgage.

This is not a good thing however. Those with debt may be bailed out but savers see their hard earned money erode to a fraction of its former value. The inflation brought about by the printing of paper money effectively confiscates the wealth of many. Those close to retirement with large amounts of savings and investments are usually the hardest hit. The government cannot magic away the problem, it merely transfers the impact from one group to another. I will be writing a more detailed outlook on the impact of the coming inflation soon. Stay tuned, it will be absolutely essential reading.

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