Registered Investment Adviser Representative, Sitka Pacific Capital Management
This week Bruce is joined by Mike Shedlock. Mike is a registered investment advisor representative for Sitka Pacific Capital Management, and he also has a fantastic blog site called Mish’s Global Economic Trend Analysis. In his blog he talks about oil interest rates, housing, the IMF, Europe, gold and silver, and anything going on in the market.
Even though times are a little tough right now to be an investment advisor, Mike’s work is going very well as he says that they have a neutral market and a cautious stance. Their mission at Sitka Pacific is to avoid the next decline. They had a positive year in 2008, even though hardly anyone else did. Even without being net short they had a positive year. They don’t bet on the market going down, but rather they try to go to the sidelines, find some things they like better than others, and have huge cash positions. This is where they’re at today. For the last year the stock market has gone up, and they have more or less been on the sidelines. NASMP was up 12-15%, while they were only up 6%. They don’t really like the risk award setup, as they believe that the odds are good that another recession is coming. They think the recovery is not real and is only based off of fiscal stimulus both from Congress and monetary stimulus by quantitative easing from the Fed that’s not sustainable. Both are coming to an end, and the Republican Congress does not want to have anything to do with larger deficit. Therefore, the fiscal stimulus is going to end unless things get extremely nasty. Global growth is slowing everywhere. In Europe, Australia, China, and the U.S. people need to be extremely cautious in terms of what they expect out of the stock markets.
Most of Sitka’s clients are in a capital preservation mode, as is Sitka themselves. The few that aren’t have left, but in the downturn they actually added to their client database significantly because Sitka missed the downturn but no one else did. They are starting to see a lot of things come together all at once. Commodities are back into a bubble; housing still has a further ways to go down, and they have already seen housing programs established. These include Cash for Clunkers and the various stimulus packages in housing. As soon as the tax credits for housing ended, housing prices went back down. To work with this, Sitka delayed things for a year expecting that home prices are going to fall to where they’re going to get anyway. Prices are going to fall until price meets genuine demand, not artificial demand coming from Congress. The very best thing that Congress can do for the housing market is to do nothing. They need to let prices fall, let foreclosures happen, and let prices get to where there is genuine demand. It’s then we can find a bottom. The more Congress tries to delay this, the longer and further off the bottom is going to be.
According to Mike, “Things don’t get where they’re going in a straight line.” This has a lot to do with intervention, which doesn’t change the ultimate direction but rather the timeframe in which something happens. This is why being an investment advisor is very difficult with unknown intervention. There are a certain set of people, for example momentum traders, who expect someone to catch every move in the market, both up and down. This is not something Sitka can do and most likely cannot be done at all, but this does not stop people from trying to do it or wanting to do it. The population tends to chase whatever the latest and greatest thing is right before it’s ready to plunge. This happened with housing in 2005, and it happened with the NASDAQ in 2000. Some people who were hesitant about NASDAQ all the way up from 1996 to 1999 decided right in 2000 that they were wrong and that the productivity miracle from the internet was real and they should get in before it was too late. Too many people think this is what makes the top. They think this is what made the top in 2005 in the housing market. People believed that home prices only had one way to go. Everyone had bought in. Even people who couldn’t afford a house bought one anyway. There was no one left to buy. The pool of greater fools finally ran out. This is one thing you have to be weary of as an investor. The mood of a market can definitely be opposite of the future direction. Things change very quickly. In the aforementioned situations, it changed on a dime. When it happened with housing in 2005, people were camping out and entering lotteries for the right to buy a condo. This is how crazy things were.
Another topic is deleveraging, which is inherently deflationary. Deleveraging means to pay down debt, so by definition deleveraging is deflationary. At the same time, it also depends on your definition of deflation and inflation. To Mike, deflation is a decrease in money supply and credit from mark to market, so according to this definition deleveraging has to be deflationary. However, if someone looks at things in terms of prices and they ignore home prices, for example, seeing the price of crude oil and thinking there’s nothing deflationary about it at all, then they’re not seeing the whole picture. Crude is rising because of peak oil, because of massive monetary stimulus in China, and also because of some quantitative easing by the Fed. It’s only the last that’s inflationary. What’s really funny is people complain about the price of a hamburger going up from $3 to $4 and look at the inflation, but they’re failing to look at what’s more important: the price of a condo falling from $200,000 to $35,000, or a hamburger going from $3 to $4. It’s irrelevant compared to the drop in home prices. Paying down debt is one part of deleveraging, but defaulting is also a huge part of it in real estate. This is really where the deleveraging is happening because the lenders are not getting paid the amount they have on the books. This is where Mike’s mark to market play comes in when he defines deflation as a decrease in money supply and credit mark to market. For the last year, the banks have gotten away with keeping absurd valuations on the value of their assets on the books. As long as the asset values on the books were rising, the junk bond market was going up and various things were happening that were inflationary. Mike doesn’t think the market is going to let the banks get away with it forever. The National Accounting Board, the Fed, and the FDIC have interfered with and delayed regulations 2 and 3 times now for the last three years on mark to market rules and valuing things on the books. They have kept things on the books at inflated values. As long as they were able to get away with it, we’re probably going to see another big credit scare where banks are going to have to mark some of the debt they’re holding on their books back to market. The value is going to plunge; the ability of banks to lend as a result of that will plunge. This is why banks are not lending right now. Banks are capital constraint and capital impaired, and there is few worthy credit borrowers that want to borrow. This is the deflationary backdrop; and we also have a deleveraging deflationary backdrop. In a sense, it’s really about attitudes. It’s the willingness and ability of banks to lend and willingness and ability of consumers and businesses to borrow.
There has not been willingness for businesses to borrow. If businesses were expanding, we would see it in the job market and in loans increasing. Instead, what we are seeing is the value of the debts going up on the balance sheets of banks. However, banks are not really lending and the market has temporarily suspended mark to market sanity. Instead, we have a mark to nonsense prices that have inflated the value of the stock market. For now, Mike believes that asset prices are going to plunge, commodity prices are going to sink, and housing prices have a further ways to decline. Everything, including stock prices and junk bond markets, is back in a bubble.
One thing that’s also happening is consumers are becoming willing participants in deleveraging intentionally. They have access to credit then look around and don’t want it anymore. A lot of this has to do with people trying to refinance their homes at a lower rate. They have to bring money to the table to get that lower rate because banks require a 20% down payment. If they’re 35% in the hole and banks want 20% down, then they have to bring in 15%. We’re actually seeing cash-in refinancing now rather than cash-out refinancing in homes. This is another part of the deleveraging process that is voluntary. People are doing it so that they can receive a lower interest rate on their house. One of the statistics happening now in Riverside they have never had before due to never having encumbered owners is 71% of the transactions are either short-sales or lender-owned properties. This means that 71% of the sales do not reproduce a buyer in the marketplace. Out of 1,000 sales, we have lost 710 buyers for a period of time, buy you still have 1,000 houses to move. This is the big challenge for California in that you have a lot of houses that should be on the market that probably can’t be placed on the market because there is not really an owner-occupant buyer. No one’s willing to give financing to investors. For example, Fannie Mae is not doing it, and banks are not doing it. In some extreme cases, someone wanted to put down 60% or 80% down, and they could not get the financing as it was just not available. It’s possible some small local bank might give financing, but the big banks are not interested. This should tell you how capital constrained they are and how stuffed to the gills they are with mortgage debt that they actually want to get rid of but don’t know how. We also have some new rules that say the banks have to take 5% of the mortgage and keep that at risk on their balance sheets so they can’t securitize all of it. Banks don’t want any part of this either, so we have had an attitude change on the part of buyers and on the part of the lenders. Lenders don’t want to lend, and people are waiting for cheaper prices because they think they’re going down. It’s the confluence of these two attitudes and willingness and ability of banks to lend and willingness and ability of businesses and consumers to borrow. If you were a business, you would have no reason to expand in this kind of environment. Any business who wants to expand here should be turned away as a poor credit risk because they don’t know what they’re doing.
One thing that needs to happen is we need to get rid of Fannie Mae and Freddie Mac. In the short-term, real estate will be affected by the cost of obtaining a mortgage being raised above a specific amount. The amount that Fannie Mae would be willing to finance is going to go down. Anyone who wants to buy a home above that amount is now in a jumbo loan instead of in a regular loan, and a jumbo loan has a higher interest rate assuming they can obtain it at all. Withdrawing Fannie and Freddie from the marketplace will result in downward pressure on real estate prices, which is actually a good thing. The sooner the prices get to where they’re going, the better off we are. If this means that 30-year mortgages completely vanish, this is a tremendous thing. People should not be buying houses unless they have an expectation that they can pay it off in ten years. Obviously not many people have been able to do this and not at the prices that homes were at in the market. Fifteen years is a more reasonable timeframe. Instead, at the peak of the insanity, we were going into 40-year mortgages, others 50 and 100. If you need a 100 year mortgage to make something affordable, then it’s not affordable. Mike also feels the same way about 30-year mortgages. There should not be any reason for there to be mortgages longer than 15 years. If someone wants a 30-year mortgage, maybe they need to pay a lot more because there is a lot more risk. With 30-year mortgages, people are not paying the principle back fast enough, so in any downturn that comes there is going to be less equity and more likelihood for someone to walk away from it. Someone who had to pay the house back sale over 12 years, not counting those who bought right at the tip of the bubble, would have some equity built up. In fact, over the course of ten years they would have had their house paid off.
In regards to accessing the equity for business purposes, Mike would tell people not to do it. People thought there was free money available. They thought since the home prices went up they should take the money out and invest in the stock market. Very influential people actually advised others and wrote books telling people to take money out of their houses and invest in foreign equities because they only go up. It’s all part of when you leverage in this way the risk goes up. With the price destruction we have had in California, at some point the price of houses will be so far below replacement costs that there is no way to pencil in new construction. We will probably have a double-dip in some of the inventory types because of the lack of buyers and the quantity of inventory. Mike wrote a post three years ago titled “Structurally high unemployment for a decade,” which talked about how eventually when we get to the lowest possible price level, the job market probably will not return. We will have consistently high unemployment for a long time. At the height of the housing boom, we were creating about 250,000 jobs a month. At the height of the commercial real estate boom, which lagged and kept the economy going due to the subdivisions and strip malls being built, they were only averaging about 190,000 jobs a month. Unfortunately, the commercial real estate is not coming back as we’re not going to have another boom or another housing build out like we did originally. It takes 125,000 jobs a month to keep up with birth rate and immigration, so even if we did keep up with it, we’re going to have an unemployment rate at 8% all the way up until 2014. The unemployment rate right now would be 12% except for all the people who dropped out of the work force. They dropped out a faster rate than was thought, hence why unemployment is not making new highs right now. It’s at 9.1% right now and 10.1% at its high. We have added hardly any jobs since then, so now oddly we are heading into another recession with no telling where it’s going to go. We may not even lose that many more jobs. Housing is already trailing towards the bottom, so there’s not much to lose if we head back into another recession. However, you can still expect to see the unemployment rate shoot back to 10%.
To hear more from Mike Shedlock, you can visit his website at globaleconomicanalysis.blogspot.com. For a quick search, type Mish in Google.
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