Registered Investment Adviser Representative, Sitka Pacific Capital Management
This week Bruce is joined once again by Mike Shedlock. Mike is a registered investment advisor representative for Sitka Pacific Capital Management.
Mike’s blog, Mish’s Global Economic Trend Analysis, was started back in 2005. Before, he had worked in the banking industry for over 20 years as an assistant vice-president for Harris. He then became a consultant in 1999, but the consulting jobs dried up after Y2K and 9/11. For this reason he was out of work for almost 3 years. He started his blog with the intent of being discovered, which originally he thought the odds were 0, but he proved himself wrong. He now gets a million and a half to 2 million page hits a month on his blog. He initially started writing about the things that he was going through at the time that a lot of people are going through right now. I could see the bubble in housing building, and people were telling him “Cash is miss, cash is trash,” but when you are out of work cash is not trash. Now, most of the people who told him this have actually lost money on their houses. He wonders how many of them would like to have their cash back in their pockets now that they’re unemployed. However, very few people listened. Bernanke tried to claim the housing bubble didn’t exist, but it was very easy for Mike to see it did indeed exist. He called the exact top of the housing market on his blog in real time in the summer of 2005. Some people tried to say that Case-Shiller showed the peek was in 2006, but Case-Shiller only looks at re-sales and not at new home sales. What started happening in the summer of 2005 that didn’t reflect itself in prices was huge incentives, whether it was free garages, free trips to Europe, free cars, free swimming pools, free landscape upgrades, free granite counter tops. It actually started with the free granite counter tops, and then it went as big as free pools. Case-Shiller never picked up any of this. Housing peeked in 2005, and it took another year for things to start heading down in earnings. The same type of thing happened back in 2006 when there was an 18% commission to sell a house in Phoenix.
One of the things that was very difficult about picking a top accurately back in 05-06 was you would have really had to understand the way real estate was being financed, and very few people understood what a mortgage-backed security or a CDO or a fault-swap until around 2007. Part of the problem was possibly a disconnection between the ways things were really being financed and how little the lender cared if anybody really could pay. However, it’s really hard to say what was going on in Bernanke’s mind, but he certainly did miss the housing bubble. He didn’t think there would be a recession and said, “The housing prices were supported by fundamentals” and mentioned there possibly being some “local froth.” Neither he nor Greenspan saw the role of the Fed’s interested rate. It’s interesting to ask how much of what Bernanke said he really believes or if he is simply trying to absolve the Feds’ guilt. Last week he did a very self-serving speech where he praised the Feds for doing things that caused the recovery, but ignored all the things that the Fed did that caused the bubble in the first place. Greenspan was a veritable cheerleader for housing, preaching variable interest loans, adjustable rate mortgages. He was praising derivatives and all the things we would look back on as silly. One did not need to understand credit derivatives or anything like that to know housing was in a bubble. All one needed to see was how fast home prices were rising vs. how fast wages were rising. Home prices were 3-4 standard deviations above rental prices and 3-4 standard deviations above wage growth. It’s simply not sustainable. That is how out of line home prices were. We’re closer now to being back at the trim line, but we’re still a little bit above it.
The tendency, however, is to overshoot to the downside. Should that happen, there is a chance for some significant declines in places like California. Home prices look a lot cheaper in Las Vegas because the bigger the bubble the bigger the decline. Some of the biggest bubble areas were Las Vegas, Florida, Phoenix, and a lot of places in California. California still has not corrected to where it needs to go to where one would say the valuations are reasonable. California also has Proposition 13, which is putting a floor on home prices. Some cities, such as Chicago, New York, and San Diego, are always going to have a premium because these cities are where there are a lot of jobs. However, there is a difference between premium and 300-400% and 3 standard deviations like we were above norm. A deviation is a mathematical function of a normalized curve that shows just how insane things are. Three times normal is an extremely low probability event, and when you get into that condition, you know that you’re in a bubble. Australia, Vancouver, Canada, and China are in this same situation right now. You can look at all these places and see that home prices are going up faster than rents and faster than wage growth. It’s not sustainable. The bubble in Australia has now popped, but all the mentioned countries were in a bubble longer than expected. When Canada’s and China’s burst, we are most likely going to see some 50% declines just like here in the United States.
There are a lot of smart people who disagree with the direction the market is going and believe we need to protect against strong inflation. However, before you can hear their arguments and debate you have to know what the terms mean. Mike defines inflation as an increase in money supply and market to market credit. A common definition people use for inflation is prices going up, and they look at consumer prices. Unfortunately, they ignore asset prices, which is one of the mistakes Bernanke and Greenspan made. They absolutely ignored asset prices and did not consider home prices as part of inflation. Had you taken home prices and put them in the CPI, then interest rates in the initial stages of the bubble popping were 5-6% too low. You put housing in the CPI; the CPI would have been about 8 or 9%. Instead, interest rates were 4 1/2%, so there should be no wonder that speculation in homes was running rampant when interest rates are that low. On the contrary, people today say inflation is going through the roof, but you have to ask if it really is. If you put home prices in the CPI, we now see something different. The CPI would be barely flat here now. This is what happens when you ignore asset bubbles and don’t put them in the CPI. This is what happens when you only look at prices. It’s not even really possible to measure prices. If you take a look at the CPI, this is a basket of goods and services, and there is not one representative basket. Take for example someone who is on fixed income and retired. They are going to care the most about gasoline prices, their heating bill, property taxes, rent prices, the prices of food, and medicine if they are not fully covered by Medicare. If also, for example, you take the basket of someone with kids in high school heading for college, you see the cost of college education has doubled in the last ten years or less. Someone can easily rack up $50,000 a year in expenses going to college. Kids are racking up $100,000 in debt. These are two different kinds of baskets, not one representative basket. Therefore, the whole idea of thinking you can measure the CPI is flawed.
Mike has a letter on his website from a lady named Stephanie who is retired. To Stephanie, inflation meant her fixed income bought less. She said she gets $938 from Social Security, which is what she lives on every month. She has a cd that has $16,000 in it, which she was getting $75 a month on the cd at one time. Short-term interest rates are now down to nothing, so she is getting nothing on $16,000. She wrote Mike asking him for advice, and he responded saying that she was being clobbered by the policies of the Fed. Not only did the taxpayers bail out the banks at their expense, but the Fed continues to do so. When Bernanke holds the interest rates so low, he is hurting everyone on fixed income that has savings in cds or receives a social security check every month that buys less and less. These are the people that Bernanke is hurting. Norio Rabini just came out with a statement that he thought there could be quite a shaking up of bonds and yields in the next couple years. Mike mentioned this possibility too, although it is uncertain. He received an email recently asking this very question, and they got upset when he didn’t know. However, the real answer is anyone who thinks they know is probably lying. No one really knows. We can put together our guesses and make a case why we think something is going to happen, but when someone says they know, they really don’t. We don’t know what the Fed is going to do, or what the ECB is going to do, or what China is going to do. Everything is intertwined. China is having a government change in 2012, something of which not many people are aware. It is going to be a very significant one. The current leadership in China is focused on maintaining growth at any price. It is highly rumored that the next regime coming into China is extremely concerned about the property bubbles. If they slow the Chinese economy, slow the prices of commodities, drop oil, drop the CPI, and if Congress sticks to its policies of being fiscally conservative, we may still be running huge deficits, but we’re no longer adding to it. This is a change in the direction of downward pressure on the dollar. Last year the ECB thought Jean-Claude Trichet was going to hike prices last month, and he didn’t. If the ECB doesn’t hike, this is going to put upward pressure on the dollar and downward pressure on the Euro. All of these claims are being put out there, but most of the claims are lies; the people don’t really know. However, Mike is very supportive of what Rabini said about there being a legitimate chance of a bond market revolt. On Yahoo Finance Mike talked about this very thing. He was on the air with Aaron Task and Henry Blodget and had mentioned it two weeks before Rabini had even mentioned it. He said if they get another round of QE out of the Fed, there is a real risk of a bond market revolt. However, if he doesn’t and delays off on it, if there is a stock market plunge, if Europe delays hiking, if Australia does rate cuts, China slows, and commodities come down, then we can see a flight to treasuries. As of which one of these things will happen depends on where all the variables fit. It depends on what China does, what the ECB does, and what the Fed does. Only then can we have a more definitive answer.
The Fed will attempt to inflate, but it would be better for us to bite the bullet and balance the budget. Otherwise, there is a very big risk of what happened in Greece happening in the United States if the U.S. does not address its budget deficit. Interest rates do shoot up, and this is a very real risk. If we want to get back to growth policies, we need to balance the budget. We’re already spending $750 billion on defense, and we could probably spend $100 billion and have enough defense. We could also allow drug imports to come in from Canada, get rid of student loans, or kill the entire department of energy. There are a lot of things we could do that would get this country back on fiscal track. We can’t balance the budget in one year, but it is possible that someone can do it in 5 years. There is not really a choice here. If we continue on the current path of not tackling the deficit, then what’s going to eventually happen is something similar to what happened in Greece. The path we’re on is unsustainable. The sooner the Congress addresses this, the better. The sooner they address it, the sooner housing, commercial real estate prices, and the stock market will be negatively impacted. No one wants to see this happen; no one wants to see the short-term pain. However, the long-term pain gets greater and greater just like what happened in Greece if we don’t address the problem.
The U.S. has been following the path of Japan, which has had a 20-year run with their housing market. It seems we are still on this path, and even if the Fed does manage to obtain a little bit more inflation, home prices will probably not go anywhere for a decade due to the deleveraging of consumers. All the people out there who are thinking housing is at a bottom and better buy now should forget it. We are not going to have hyperinflation, and home prices are going to be stagnant for a long time.
To learn more, you can view Mike’s website at globaleconomicanalysis.blogspot.com, or type Mish in a Google search. He talks about housing, interest rates, Europe, gold, silver, and the global economy every day of the week.
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