Toro's Running of the Bulls Market Blog

Canadian Housing Bubble, er "Market" Update

In our never-ending quest to profit from the works of others, we here at Running of the Bulls present to you two papers on the Canadian housing market, which is a bubble, or kinda bubble-like, at least in some places.

First off is an update from Alexandre Pestov (HT ZeroHedge) who updated his original paper we highlighted a few months ago.  An abridged version follows.

Canadian home prices in May 2010 (Exhibit 1.1) were up 13.6 percent from a year earlier, according to the Teranet - National Bank National Composite House Price Index™. The 12-month gain was strongly influenced by Vancouver, up 17.1 percent, and Toronto, up 16.0 percent. In the other four markets surveyed, the 12-month rise ranged from 5.6 percent in Halifax to 11.4 percent in Ottawa. In Calgary it was 7.8 percent and in Montreal 8.5 percent.

During the 10-year span between May 2000 and May 2010, housing prices increased 96 percent nationwide, 118 percent in Calgary, 116 percent in Montreal, 69 percent in Toronto and 126 percent in Vancouver. Doubling of housing prices over the 10-year period coincided with the all-time highs in nominal terms in the three major cities except Calgary where prices remain 8.6 percent below their stratospheric highs set in August 2007. Year-over-year and from May to June 2010, nominal home prices edged higher in all key markets without any surprises.

Home prices should rise at the nominal rate of GDP, plus or minus variations in local markets.  Home prices are also affected by other factors, such as mortgage costs.  Doubling of home prices in 10 years implies a compound rate of 7% per year, above the long-term trend in nominal growth.

The significant decline in sales year-over-year was observed uniformly across Canada ... The new mortgage regulations and exhaustion of an adrenaline boost from the HST scare in British Columbia and Ontario inflated sales volumes in the months preceding June 2010, and led to very disappointing, albeit predictable, results in June.

In June, volume from a year ago fell 40% in Calgary, 19% in Montreal, 23% in Toronto and 30% in Vancouver.

It is an old adage in trading that a market rising on declining volume is a market not to be trusted.  It is a hallmark of a market top.  That does not mean that the Canadian housing market is topping, but it is a sign that it may be.  The exact same thing happened in America at the top of the US housing bubble when prices continued to rise even though volume fell off a cliff.

Commencing 2007, the new dwelling starts, completions and units under construction experienced a sizable correction. Despite these changes, the number of units set to be constructed in 2010 now exceeds the long-term average, indicating a continuous oversupply of homes. The sharp reduction in number of new starts and completions was softened by the 2000-2007 swelling of dwellings under construction. The number of units remaining in the pipeline will fuel additional supply of homes released into the market and in spite of the declining dwelling starts the overbuilding is expected to continue for into foreseeable future.

Supply is increasing whle demand is decreasing.

In one of my first Econ 101 classes, I learned about the elasticity of supply over the short and long run.  Elasticity of supply means how supply changes based on the change in pricing.  My professor used housing as an example.  In the short run, housing is very inelastic, i.e. small changes in demand for housing has a disproportionate affect on pricing since homes cannot be built in a day or two.  It takes a while to build a house.  Over the long-run, however, the supply of housing is very elastic. As home prices rise, builders respond by building more homes.  There is a lagged response but the supply gets built. This is what can make homes a bad investment.  Demand for housing can change dramatically while supply is being brought onto the market, exacerbating negative shifts in pricing.

Not only is home supply rising, so are vacancy rates.  Apartments add to the supply of housing.  When vacancies rise, supply has risen faster than demand.

Affordability has improved but it is still expensive to buy a house.

It is more affordable to buy a house now compared to the 1990s only because mortgage rates are so low.

Carrying costs continue to rise.

Any increase in interest rates will have a dramatic affect on the affordability of homes.

That is because incomes have not kept up with home prices.

On annual basis, Demographia compiles a report to cover price-to-income ratios in 270-plus markets in Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States. The Demographia International Housing Affordability Survey employs median house price divided by gross annual median household income in each market to rate housing affordability values. Demographia uses the following scale to rate housing affordability:

• Severely Unaffordable 5.1 & Over
• Seriously Unaffordable 4.1 to 5.0
• Moderately Unaffordable 3.1 to 4.0
• Affordable 3.0 or Less

The scale calibration is derived from historical values observed over a period of time. According to Demographia, the Median Multiple has been remarkably similar among the nations surveyed, with median house prices being generally 3.0 or less times median household incomes. In late 2009, Calgary and Montreal were rated ―seriously unaffordable‖, scoring 4.6 and 4.9 respectively. Toronto made it to the ―severely unaffordable‖ hall of fame with a score of 5.2. Vancouver ranked the most unaffordable city amongst the 272 markets surveyed with a price-to-income ratio of 9.3 (Exhibit 4.1).

And the price of a home relative to rental income in Canada is amongst the highest in the developed world.  Not good.

Pestov compares Vancouver real estate to the Nasdaq

Though I think the two markets are not entirely analogous  - the Naz fell 80% top to bottom after the bubble collapsed, a decline that would shock me if it occurred in Vancouver real estate - I sympathize.  Some argue that such comparisons are facetious but I think they are a good representation of human psychology.

Pestov concludes that a crash in Canadian real estate is not necessarily pre-ordained, and I agree with that.  Prices can instead stagnate for many years.  However, the risks of a crash are high, particularly given the enormous problems and imbalances in the global economy, from which Canada is not immune.

Pestov does good work.  Take some time and read the whole paper.

A recent paper from the IMF differs somewhat.  The conclusions tend to be more sanguine.

Canadian house prices have increased significantly between 2003 and early 2008, with a marked downward trend since mid-2008, especially in the resource-rich western provinces. This paper estimates the evolution of equilibrium real home prices during this period in key provinces and finds that, following recent declines, home prices are now generally close to equilibrium throughout Canada. However, house prices in Alberta and British Columbia remain around 8 percent overvalued at the end of the sample (second quarter of 2009). Despite the limitations of econometric estimates of house-price dynamics, the measured small degree of overvaluation suggests that the Canadian housing market is essentially at equilibrium.

Frankly, I do not put stock in their conclusions.  The paper uses an equilibrium model.  Here are the assumpitons of the model.

The error-correction model postulates that the growth rate of real houses is explained by a combination of the following factors (depending on the province considered) ... :

• Past growth rates of real house prices. For most provinces, we find that the current growth rate is positively correlated with the past growth rate.
  
• Reversion to fundamentals implied by the long-run equation. We find that for most provinces (with the exception of Quebec and British Columbia, which is not statistically significant), the growth rate of house prices shows long-run reversion to the equilibrium prices derived from the model, implying that prices would tend to fall when they are out of line with fundamentals.
  
• Economic fundamentals. For all provinces (except Quebec which is statistically insignificant), we find that the growth rate of house prices is positively affected by (per capita) real income growth, which increases households’ purchasing power and borrowing capacity. The growth rate of house prices is positively affected by mortgage credit growth (higher rates indicate that households are less credit rationed) in the case of Alberta. Population growth (as a proxy for the growth rate of households) positively affects house prices only in Saskatchewan.

In other words, their model of current home prices is at least partly based on past home prices.

In 2006, Fed chairman Ben Bernanke testified in front of Congress that he didn't think housing prices were overpriced. He doubted that home prices would fall much since home prices had not fallen for 60 years.  As we now know, that reasoning was an enormous logical fallacy.

Given that home prices are nine times income in Vancouver, the highest in the English-speaking world, it is hard to believe that home prices in Vancouver are only 8% over-valued.  Investors should ignore this paper.

 

Hey Saskatchewan - Don't Build a New Dome Stadium. Buy the Silverdome!

I am from the province of Saskatchewan.  Wonderful place, if you can handle weeks on end of -40C in the winter.  People are lovely.  Friendly too.

Unfortunately, they now have too much money.

Several years ago, I flagged the opportunities of Saskatchewan, as well as the nuttiness of the local economy.  When I grew up there in the 70s and 80s, it was flat broke.  Saskatchewan's biggest export was people.  Farmers were receiving hundreds of millions of dollars from Ottawa to bail them out because grain prices were so low that the farm economy was effectively bankrupt.  The government was utterly incompetent, spending hundreds of millions of dollars on subsidies for people to upgrade their homes, i.e. build whirlpools in their back yard.  The province's bonds were rated junk.  The pension fund of the capital city, Regina, was prohibited from buying the province's bonds because they weren't investment grade.  

But now, Saskatchewan is the quintessential asset-driven economy play.  It is blessed with commodities.  Saskatchewan is a major producer of grains such as wheat and canola.  It has vast deposits of potash.  And it may have extensive reserves of oil and gas, too.  The Bakken Formation extends into Saskatchewan, and some speculate that there are oil sands in the western part of the province.

In other words, Saskatchewan is loaded.

Too loaded, in fact.  It is a common phenomenon that people without money who get money sometimes blow it on unwise things.  And that is what the people of Saskatchewan may be on the verge of doing.

The City of Regina is examining the possibility of building a domed facility to replace Mosaic Stadium.

Regina Mayor Pat Fiacco said Tuesday the city is looking into what it would cost to build a domed stadium, if the move would be financially practical and how it would be funded.

“We’re doing our due diligence and we’ll go from there,’’ Fiacco said Tuesday. “It has to be affordable but we all know that it takes a bit of an investment. Someone had the vision to build Mosaic Stadium or Taylor Field at the time. For obvious reasons, we have to make sure that we take care of the next 50 years.’’

Fiacco said it was too early to speculate on the costs, size or site of the new facility. He said the city would like to build the facility close to where Mosaic Stadium is currently located.

Fiacco said that the domed stadium would be more than a home to the CFL’s Saskatchewan Roughriders, who are the primary tenants of Mosaic Stadium.

Now, I'm a huge Riders fan.  All of us from the province are.  But a domed stadium?  In Regina?

Regina

Regina has a population of 200,000.  Saskatchewan has a population of 1 million.  The province had a population of 1 million 50 years ago. 

The estimated cost of building a domed stadium in Regina is $386 million.  Given The Law of Stadium Costs - the actual cost of building a stadium will be on average double the initial estimate - such a stadium may wind up dinging the taxpayers of Saskatchewan a cool $750 million. 

This, to me, seems nuts.  The province almost went belly up in the 1990s due to incompetent government schemes and spending and a near depression in the farm economy.  A commodity-based cyclical economy without many people probably should be using its money prudently, not blowing it on extravagances such as a shiny new sporting arena.  It reminds me of those guys buying five condos on the beach they could not afford, financing it with subprime ARM loans, thinking the party will never end.

Given the fondness in my heart for my home province, I propose a better solution.  Instead of building a new domed stadium, buy the Pontiac Silverdome!  Last year, the former home of the NFL's most hapless franchise was sold for a mere $583,000.  Factoring in the The Law of Stadium Costs, that is 0.07% of the prospective cost of a domed stadium in Regina.  Think of the savings!

Of course, this presents a bit of a problem since Pontiac is in Michigan, 1351 miles from Regina (2163 km for my Canadian readers).  How do you get the Silverdome to Regina?

Well, I don't know. Someone else can figure that out.  Maybe they can dig it out of the ground, plop it on a few trucks, and drive it to Regina.  You know, like those big trucks that move pre-manufactured homes place to place, with the smaller trucks decked out in orange and yellow trailing behind, going 20 mph below the speed limit.

Or maybe the province can just fly everyone to Michigan.  They could spend $700 million transporting all the spectators to the Silverdome.  They would still be better off than building a domed stadium.

That may not make much sense, but it seems to make a whole lot more sense than a province the size of Texas with the population of San Jose CA and one of the most cyclical economies on the planet that was just recently on the brink of bankruptcy building a domed stadium for hundreds of millions of dollars.

Canadians' Indebtedness Continues to Rise

As regular readers of Running of the Bulls know, I'm pretty lazy.  That's why I am just now getting around to posting on a report published by the Certified General Accountants Association of Canada (CGA) a few weeks ago on Canadian household debt entitled Where Is the Money Now: The State of Canadian Household Debt as Conditions for Economic Emerge.  And that debt is growing.

Since inception, Running of the Bulls has highlighted the nutty Canadian housing market.  It is the position of this blog that home prices in Canada are bubbly, at least in some cities, and that The Canadian Housing Bubble will end like all bubbles, badly.

Upon making this argument to disbelieving Canadians, pushback one receives is that "there is not much subprime lending in Canada."  My retort is, "So?"  There was no subprime lending during the last housing boom in Canada either, when home prices in Vancouver and Toronto were cut by a third from their 1990s peaks.  Subprime debt is not a necessary precondition to fuel a housing bubble.  What fuels asset bubbles is debt, and a lot of it. 

And a whole of credit is flowing in the Canadian economy, according to the CGA.  From the report.

• The level of debt adjusted for inflation and population growth shows a continuous upward trend over the past two decades, as well as in 2008-2009. In fact, if household debt was to be evenly spread across all Canadians, each individual would hold some $41,740 in outstanding debt in 2009, an amount 2.5 times greater than in 1989.

• Starting in 2003, the dynamic of household debt has changed significantly, shifting towards a high growth rate. For more than six years, the rate of credit expansion has been higher than the long-term average of 4.5%. Unlike the 1990s though, the accelerated extension of household debt was no longer supported by a similar magnitude of economic growth in the mid and late 2000s.

• The debt-to-income ratio reached a new record high of 144.4% at the end of 2009. Debt-to-assets reached 19.4% at the end of 2009, while its average for 1990-2007 stood at 15.2%. Although the debt-to-assets ratio did not deteriorate further in 2009, this stability was mainly attributable to the increase in market value of financial assets in the second and third quarters of 2009.

• The degree to which residential mortgages were backed by residential assets continued to deteriorate over the past two years. This erosion pushed the mortgage-to-residential assets indicator to 65.4% at the end of 2009, a level much higher than the 55.0% average observed between 1990 and 2007.

• The decline in interest rates and lower effective interest paid (expressed as a ratio of interest paid to outstanding debt) did not help households to reduce the share of their income dedicated to debt servicing. Instead, mortgage and consumer credit debt service ratios stayed unchanged in 2009, but were somewhat higher compared with the levels observed in the mid-2000s.

• The true cost of supporting mortgage debt may be significantly understated because debt-service ratio does not take into account such compulsory obligations as mortgage principal, property tax, mortgage insurance premiums and condominium fees. For instance, in Alberta, property taxes and condominium fees added some 27% to an average debt-service ratio for mortgages in 2008.

• The amount of outstanding consumer credit per each dollar of consumption of goods has increased significantly over the past years, suggesting that households are either using increasingly larger amounts of credit to buy the same quantity of durable goods, or that households may have increasingly adopted a practice of using consumer credit for purchasing non-durable goods.

• Some 79% of household assets may be affected by the changing dynamic of real estate or financial markets. The composition of household assets over time has become riskier, less diversified and somewhat less liquid. Stocks and mutual funds accounted for 19.2% of all household assets in 2009, more than double when compared with the level seen in 1990. Holdings of lower risk cash and deposits, in turn, decreased to 12.3% of household assets, down from 18.0% in 1990.

• Households’ exposure to rising interest rates increased. The proportion of household debt with variable rates increased from 14% in 1997 to 25% in 2007. This proportion is even higher for mortgages: in 2009, some 27% of mortgages had variable-rate terms while another 6% employed a combination of variable and fixed rates.

• If the mortgage interest rate goes up by two percentage points, mid-income and mid-to-high income families may be required to tighten their budgets by cutting an estimated 9%-11% from ‘other expenses’ if they are to maintain the current levels of spending on food and transportation. The ‘other expenses’ includes household furniture and equipment, clothing, health and personal care, education, recreation, personal insurance, pension contributions, etc.

Rising debt continues to be primarily caused by consumption motive rather than by asset accumulation. Some 56% of respondents said that day-to-day living expenses are the main cause for the increasing debt; 4 percentage points higher than the 52% reported in 2007. In turn, outlays that could potentially attract a return, such as purchasing of a residence, enrolling in an educational program or spending on healthcare, were among the least likely causes for increasing debt. ...

Some good news.  Debt to income was middle of the pack compared to the OECD.  But, given the problems in the global economy, that is hardly comforting.  Canada ranks first in consumer debt, however.

From 2006 through 2009, consumer credit rose 41.7%, or 9.1% per year.  Mortgage debt rose 46.3%, or 10% per year.

That is more than double nominal GDP growth of 18.8% from 2006 through 2009, or 4.4% per year.

Meanwhile, home prices are at all time highs.

 

And have gone nutty in some provinces.

 

Canadians used to be good savers.  Not any more.

Canada has done a lot of things right over the past 20 years. The country has been a major benefactor of both secular changes in the global economy as well as major imbalances in global financial markets.  Those imbalances only partially corrected during the past recession, while new imbalances have been created and there have been few fundamental changes in the Asset-Driven Economy.  Ultimately, when the imbalances re-balance, Canada will be hit. I do not want to own assets supported by low interest rates and excessive debt, no matter how cool the country or how good the hockey team.

Crash

I have no idea what caused the collapse intra-day today, whether it was a bad trade or the withdrawal of liquidity by the machines or what.  What I do know is that it was amazing to watch.  At one point, the Dow was down nearly 1,000 points.  I have never seen anything like it.

I got lucky.  On Monday near the close, I hedged out all my equities positions to net flat.  I had also been buying gold calls the past week and have been long the dollar since the beginning of April.  So my book since Monday's close has been long gold, long the dollar.  

I closed out most of my dollar long position and have kept only a small position.  That does not mean the euro is going to rise.  In fact, it will probably keep melting down.  Remember, it was 85 cents several years ago.  And on a purchasing power parity basis, it is worth $1.15-$1.20, so it is still expensive.

I am a long-term bull in gold but have traded in and out of the yellow metal over the past eight years.  I started buying a week ago when the price action was acting very well.  I expect that we will go back and re-test the $1225 highs, back off a bit, then blast through it.  I expect to add to positions on a break to new highs or on a light pullback.

My equities book right now looks primarily like this - long small banks, long semiconductors, short the S&P 500 and Russell 2000. 

Over the past year, I have been buying banks, primarily very small banks.  My criteria for banks has been to buy stocks trading below tangible book value that made money through the crisis and are forecasted to make money this and next year.  I own 14 banks, most that trade by appointment.  I hope to add to my bank position during this sell-off.

My semiconductors position is now a residual of a basket that I began building in 2008, and continued to buy through the end of the year and into the Spring of 2009.  At one point, I owned 18 different chip companies.  I have sold most of my basket and now own six names.  I will sell into strength.

The hedges I own are the Direxion Russell 2000 3X Bear ETF, ticker TZA.  I own the double inverse Horizons S&P 500 Bear Plus ETF in my Canadian RRSP account, ticker HSD.TO.  I also hold the double inverse Horizons S&P/TSX 60 Bear Plus Fund, ticker HXD.TO for other accounts I manage in Canada. 

My intention in buying the leveraged inverse ETFs was not to short the market but to eliminate equity beta.  Since Monday afternoon, my net position became net short, so I peeled a small part of my hedge.  Interestingly, during the 600 point 20-minute plunge this afternoon, I tried to sell some TZA, which is normally pretty liquid.  However, it did not get filled, even though I kept it open for 20 minutes. I pulled the order as the market bounced.

I have been expecting a 5%-10% correction for some time now.  Today, we got it, with the S&P 500 down 13% intra-day from the highs of a few weeks ago.  I had thought it would merely be a correction in the midst of a cyclical bull market. I'm not so sure now.  This may be a correction within a cyclical bear market but I must respect the action, and the market action today was just horrible, no matter what the reason for the sell-off. 

Sovereign debt crises are very serious, and must be respected.  I expect more downside pressure in the near-term.

Canada's Day of Reckoning Approaches

Today, the Bank of Canada signaled that it will soon start increasing interest rates.

The Bank of Canada is sending a clear message that interest rates could rise as early as June, signalling a turning point in the recovery and triggering a debate on how fast and how high rates will move.

The central bank kept its key rate steady at the rock-bottom level of 0.25 per cent at its policy meeting Tuesday, but removed key language that had pledged to keep the benchmark at current levels through the middle of the year.

That move contributed to growing expectations that the central bank will raise rates as early as June 1, its next policy decision, and sent the dollar soaring again.

Yet, Canadians have been piling on the debt.

Canadian borrowers are fast approaching a day of reckoning.

Lured by cheap money to buy up, buy in, expand and make over, families have pushed credit levels to a record high.

Now, mortgage rates are beginning to creep up and the Bank of Canada is poised to retreat from the record-low interest rates it adopted to fight the recession and spur recovery.

The end of the free-money era has left consumers more vulnerable than ever, and those who threw caution to the wind could soon face costs they can't handle.

Household debt has surged three time faster than income in recent years and now stands at a record high of more than $1-trillion. Put another way, Canadians owe about $1.47 for every dollar of  disposable income. Even more remarkably, they took on more debt during the slump – a first for a recession – because borrowing was so cheap.

With debt levels this high, even a small hike in interest rates will be ugly for those whose incomes aren't rising fast enough to meet their day-to-day expenses.

Their woes could have a snowball effect: As debt-strapped consumers pull back, their credit woes spill over into the broader economy and risk putting a damper on the recovery. ...

Most of the increased debt, roughly 70 per cent, has been in mortgages, reflecting the still hot housing market in much of the country. That has left many households struggling to meet monthly payments on hefty mortgages and more susceptible to rising rates. Families in Vancouver, for example, spend about 68 per cent of their disposable income on the cost of maintaining their house, compared to less than 40 per cent 10 years ago.

“There's been a real frenzy just to get in [to a house] at all cost, because if you don't get in you may never get in,” said Scott Hanah chief executive of the Credit Counselling Society, a non-profit group based in Vancouver that helps people sort out their debts. ...

Canadians used to be big savers and cautious borrowers. In 1982, Canadians socked away 20 per cent of their disposable income and per capita debt stood at about $5,500, according to Statistics Canada. By contrast, Americans were saving just 7.5 per cent of their disposable income at that time and borrowed $6,500 per capita.

Savings and borrowing soon went in opposite directions in both countries and by 2002 debt levels surpassed disposable income for the first time. In 2005, the savings rate in Canada fell to 1.2 per cent, about the same as in the U.S. Meanwhile, per capital borrowing jumped to $28,390 in Canada and $48,700 in the U.S.

Consumers are feeling the pinch. A survey last year by the Certified General Accountants Association of Canada showed 21 per cent of respondents could barely meet the interest payments on their loans. The group is about to release a similar survey this year and, said the group's chief executive Anthony Ariganello, the level of those struggling to cope has climbed to about 23 per cent. ...

In a recent report, Mr. Tal concluded that “Canadian consumer fundamentals are weaker than they have been in almost 15 years.” ...

We commented about the Canadian Housing Bubble not too long ago.  Canadian mortgage rates are at multi-generational lows.  Even a small rise in mortgage rates will hurt Canadians' pocketbooks. 

Housing bubble.  Rising debt levels.  Sound familiar?  The end game is also likely to be familiar.

Canada has been good, but Canada has also been lucky.  Easy money arising from the Fed's zero interest rate policy has flowed into Canada, arresting the collapse of the Canadian housing market before it really started to accelerate, sending home prices north of the border to record highs.  When money begins to tighten, Canada could become extremely vulnerable.

What could save Canada?  The Fed's zero interest rate campaign to debase the dollar helps real assets, particularly commodity prices, which benefits Canada.  If the Fed's policies remain extremely easy, then Canada's inevitable housing collapse may be buffeted by relatively high commodity prices.

Long term Running of the Bulls readers may think I'm talking my book, as two months ago I stated that I was short Canada.  A few weeks ago, I covered all my shorts and am now long Canada and risk assets in general (ensuring that a correction is imminent - ed.).  Generally, asset markets collapse when monetary policy is tight.  Monetary policy is currently very easy.  Usually, asset prices rise for some time after the first increase in rates by the central bank.  I have been looking for a 5%-10% correction for some time, and that may happen.  However, I expect stocks to be higher in the future.  But at some point, you are going to want to be far, far away from Canadian (and global) stocks.

Follow the Nuttiness of Vancouver Real Estate

We have been talking about the nuttiness of Canada's real estate for some time, most recently here. 

There is nowhere more nutty than Vancouver, and it is demonstrating the classic signs of a bubble, including frantic panic buying.  

You can read all about real life experiences at Vancouver Real Estate Anecdote Archive.  (HT Paul Kedrosky)

Vancouver, CrackShack or Mansion?

With the average price of a house in Vancouver over $1 million these days, its difficult to know if you are buying a crackshack or a mansion?

The Canadian Housing Bubble

Since the beginning of this blog, we here at Running of the Bulls have spent considerable time detailing the wackiness of the Canadian Housing Bubble, which you can read here, here, here, here, here,and here.  The Running of the Bulls thesis for why the Canadian Housing Bubble has not popped in a similar manner as the American Housing Bubble is here.

Alexandre Pestov has written an excellent paper entitled The Elusive Canadian Housing Bubble.  Pestov is an MBA candidate at the Schulich School of Business at York University. (Toronto's second best MBA program!)  The following are exerts from Pestov's paper.  (HT to Zero Hedge.)

First, Canadian mortgage rates are at six-decade lows.

Those arguing that home prices are not a bubble say that housing is not particularly unaffordable.

The problem with this argument, as Pestov rightly points out, is that interest rates are at multi-generational lows.  In Canada, all mortgages are fixed only for a specific period of time, i.e. 5 years.  Interest rates reset thereafter.  When interest rates normalize, homes will become even more unaffordable.

Citing a report on the Canadian housing market by RBC, the paper notes

• An average Vancouver household (that is a family of usually two income earners, not a single person) spends over 70 cents of every pre-tax dollar they earn on house ownership costs. Deduct unavoidable taxes, and this amount would rise to nearly 100 percent of an average household income in Vancouver
• An average Toronto and Montreal household spends over 57 and 47 of their pre-tax income on house ownership costs, or nearly 80 and 70 percent of their after-tax income respectively

Home price increases have far outstripped rising incomes.

Over the last 13 years, house prices in Toronto, Montreal, Vancouver and Calgary rose 5-10 times quicker than incomes in these cities. Incomes simply did not keep up with the rising home prices. Housing affordability (or un-affordability would be a better term in case of Canada) is significantly above its long-term average now. While it is lower than that at the peak-bubble in 1990, it is expected to skyrocket into the stratosphere once the bank rates rise and the mortgage rates follow. Despite the historically low mortgage rates, housing affordability in Vancouver is close to being the worst on record (the actual record was set less than two years ago). Once bank and mortgage rates gravitate towards their long-term average, housing affordability in Vancouver will approach 100 percent. In other words, an income-earning family in Vancouver would have to spend every penny they earn on housing costs. This is in addition to learning tax evasion methods, as this 100 percent would be of their pre-tax income. While not as dire as it is in Vancouver, housing affordability of Toronto, Calgary and Montreal will deteriorate and likely exceed levels seen during the last real-estate bubble.

 By international comparisons, home prices in Canada are very high.

The annual Demographia International Housing Affordability Survey reveals surprising results. Predictably, during the peak of the US housing boom the affordability measurement in cities including Los Angeles, San Diego, Honolulu, and San Francisco reached double-digit levels. In retrospect, it is hard to comprehend the rational and thinking process of buyers snatching houses they wouldn't be able to pay off during their lifetime. Vancouver didn't trail far behind, staying solidly in the “severely unaffordable” category and surpassing both London, UK and New York, NY by mid-2006. During that time, Calgary and Montreal gradually rose from “moderately unaffordable” levels to “seriously unaffordable”. Toronto, being excessively pricey already, stayed within the “seriously unaffordable” band.

Once the bubble burst and home prices plunged, the affordability improved in the most overpriced cities in the US and UK. But not in Canada. Instead, the housing affordability average in Canada moved closer to the upper boundary of the “moderately unaffordable” band. Instead, the mean house price in Canada became less affordable than that of the US. During the crisis, Montreal and Calgary edged dangerously close to crossing the “severely unaffordable” line, while in 2009 Toronto finally managed to turn itself into a “severely unaffordable” city. And Vancouver outshined them all.

In 2009, Vancouver became the most unaffordable city among 272 markets. Presently, Vancouver is less affordable than London, UK, Los Angeles, CA, Miami, FL, New York, NY, Sydney, AU or any other city in Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States. ...

On the median multiple ratio measurement, Vancouver (9.3), Toronto (5.2), Montreal (4.9), and Calgary (4.6) hover substantially above the “normal” 3.0 level. Based on this valuation, Toronto is considered a “severely unaffordable” city, while Montreal and Calgary lie on the border between being “seriously unaffordable” and “severely unaffordable”.

By other valuation measures, such as price-to-rent and price-to-income, homes in Canada  are expensive.

Since the financial crisis began, mortgage credit in Canada has expanded primarily through the government.  CMHC MBS securities have doubled since 2007 whereas private credit has barely budged.

Nearly 90 of mortgages issued between 2007 and 2009 were securitised. By the end of 2007, there were $138 billion in MBS that is guaranteed by CMHC, which covers approximately 17 per cent of all outstanding mortgages. By July 2009, that figure rose to $290 billion. CMHC's stated goal was to guarantee $340 billion by the end of this year and is on track to reach $500 billion by the end of 2010, which would be would be equal to 1/3 of the Canadian GDP. In fact, between 2008 and 2010 CMHC‟s issuance of MBSs will likely exceed the combined total issued by CMHC in its 62-year long history prior to 2008.

The volume of home sales has exploded.  This is typical of highly speculative activity.

Furthermore, the data series shows that sales more than doubled from 1980 to 1997, and then nearly doubled again by 2007. At the same time, the population of Metro Toronto increased just 13 percent from 1980 to 1997, and approximately 20 percent between 1980 and 2007 (Statistics Canada; Toronto.ca). In 1980 home sales stood at 12.8 per 1,000 citizens of Toronto. In 1996 this number increased to 25.0, and by 2007 they reached 37.6.

Debt held by Canadians is at an all-time high.

 

Including, predictability, mortgage debt.

Mortgage debt has fueled an explosion in residential construction.

The Canadian Housing Bubble can go on for awhile.  As long as interest rates are low, the yield curve is steep, China's stimulus is working its way through commodity markets, and the world avoids a serious sovereign debt crisis, the Canadian economy should be okay.

But the laws of economics have not been suspended for Canada, no matter how wonderful the country may be.  The Canadian Housing Bubble will end no differently than past housing bubbles.

Foreign Direct Investment Has Benefited Canada

Canada has long had a love/hate relationship with foreign direct investment (FDI).  FDI brings economic activity and jobs but conjures up fears of foreign takeovers, especially by the United States.

However, FDI is unequivocally good for Canada, according to the Institute for Research on Public Policy.  Via Worthwhile Canadian Initiative.

A dispassionate analysis of the evidence shows that the benefits of foreign investment far outweigh any real or imagined drawbacks. Foreign firms operating in Canada are more innovative and productive than their Canadian counterparts, and they pay higher wages. More importantly, they import significant amounts of technology from their parent companies, and the benefits of these technologies spill over to domestic firms. In addition, though the stock of inward FDI did increase somewhat as a share of GDP in the late 1990s, it has held steady since then at just over 30 percent — the same share as in 1970.

Worries about corporate takeovers and the “hollowing out” of high-value head office functions in Canada are also misplaced. Foreign takeovers have actually increased head office activities in Canada in recent years, because foreign firms typically find it to their advantage to keep such activities geographically close to their Canadian operations.

Despite these benefits, Canada has been losing its attractiveness as a destination for foreign investment, particularly in the wake of continental free trade. Canada’s share of global inward foreign investment has fallen since the mid-1980s, because firms are increasingly locating their production facilities in the United States or Mexico to serve the entire North American market.

The debate about foreign investment in Canada ignores the fact that Canadian multinationals have quietly become major players in the global marketplace. Canadian direct investment abroad has exploded in the past 30 years, and Canadian firms now own more foreign operations (in terms of dollar value) than foreign companies own in Canada. Far from exporting jobs, this investment abroad serves primarily as a beachhead for market expansion, stimulating domestically produced exports and high value added head office activities such as engineering and design. ...

Canada has moved from being predominantly a host economy for foreign investment to being an important source economy. These investments into the global economy, for the most part, have opened foreign markets for Canadian exports, and have thus stimulated Canadian domestic investment and employment. Furthermore, outward FDI increases demand for domestic head-office activities that go beyond straight “exports” (such as engineering and design). ...

There is a stark difference between the environment today and that of 1970. Expressed as a share of GDP, Canada’s inward FDI is about the same as it was in 1970, but outward FDI is much higher. This means that the cost of “protecting” the Canadian economy by further restricting inward FDI is much higher than before in the sense that any retaliatory restrictions by other countries would have very large adverse effects on the growing stock of Canadian investment abroad. ...

[A]ny reductions in FDI designed to avoid tariffs were overwhelmed by the expansion of trade and investment flows brought on by the globalization of supply chains that broader continental free trade agreements enabled.

In addition to these trade effects, the industry-level analysis also yields important findings with respect to corporate taxation and R&D intensity. The results indicate that R&D is robustly important in attracting inward FDI into Canada. This has important policy implications, because it indicates that a fertile innovation environment is important for attracting foreign investment, which in turn leads to additional technology transfer to Canada in a positive feedback loop. Industries that have a high R&D intensity both attract more inward FDI and undertake more outward FDI.

Industry-specific Canadian corporate tax rates are found to be unimportant statistically for inward FDI, suggesting that they are not an important criterion for determining the location of FDI. However, corporate tax rates appear to have a negative effect on outward FDI. ...

With the takeover of many “iconic” Canadian firms, there has been extensive discussion of restricting foreign investment into the Canadian economy. However, restricting foreign investment would have several adverse effects.

First, it would remove the discipline imposed on managers of Canadian firms that accompanies the threat of takeover by large foreign companies. When management of any publicly traded company deteriorates, shareholders express disapproval by selling its shares. If share prices fall sufficiently, the company becomes a prime target for a takeover. With the falling stock market value, new owners can buy a controlling stake in the company and replace the management team that has been performing poorly with new managers. When foreign investment is restricted in an economy of relatively small size such as Canada’s, this threat of takeover is very much muted, and with it the discipline of managers. Investment restrictions would have a detrimental impact on the quality of management in Canada, especially in large and influential companies.

Second, limitations on investment would constrain the amount of capital available within the Canadian economy, thus raising the cost of capital. There is in fact a positive relationship between inward FDI and domestic investment. The majority of domestic credit is sourced locally, but a growing proportion comes from international sources, in the form of FDI or mergers and acquisitions. The ratio of inward FDI flows to domestic fixed capital formation has risen rapidly in Canada, and reached 34 percent in 2007. This is significantly higher than in the United States, where the corresponding proportion is less than 10 percent.

Third, FDI restrictions reduce spillover benefits from foreign companies. We have already seen that in Canada, foreign firms tend to have higher productivity than domestic firms, and in their presence, domestic firms benefit from the advanced technology and management techniques employed by foreign firms operating locally. In order for foreign operations to overcome the hurdles of going international and operate profitably when faced with competition by local firms, they must be more competitive. The domestic economy also benefits from the increased amount of competition that comes with the presence of foreign firms. These spillover effects are significant: some estimates say the spillover benefits that come from FDI are twice those of spillovers associated with trade alone

If China's Property Bubble Bursts, Short Canada

Andy Xie is predicting that the Chinese property bubble is set to burst.

As bank lending slows, “it’s very difficult to see this demand continuing,” Xie, formerly Morgan Stanley’s chief Asian economist, told Bloomberg Television in Hong Kong today.

The Chinese economy has done relatively well during the financial crisis, in part due to an aggressive stimulus program.  However, this has led to an explosion of credit, which has spawned another property bubble in China.  Credit and property bubbles rarely end well.

Growth in China has buoyed commodity markets.  Canada is a large exporter of commodities.  Canada has done relatively well compared to the US economy and the rest of the world, partly because Canada has been good but also partly because Canada has been lucky.  If the Chinese economy stalls because of a collapse in property prices, commodity prices will fall hard as China has been the global marginal buyer of all things coming out of the ground. 

Of course, Chinese demand for commodities is not the only driver of Canadian exports.  More than a third of all products and services made in Canada are exported to the United States.  However, it is my opinion that the recovery in the US will be anemic, and American stock markets may now be in the process of topping. 

(The thesis from which I am currently working is that after a large bounce, the stock market moves sideways for some time, perhaps two to five years.)

If this is the case, demand from the US will not be strong enough to offset the fall in demand for commodities from China.  Roughly half the Canadian stock market is comprised of energy and materials companies.  Canada will underperform in this scenario.

I am short Canada, and am short risk assets in general.  I believe that rallies are now to be sold rather than dips to be bought, and I plan on getting more aggressive on the short side into this rally.  I may be dead wrong, and if I am, I will quickly turn around my portfolio, and I likely won't tell you about it, or at least not in real time.

However, stocks are not cheap, the economy is weak, liquidity at best is capped and may soon be tightening, sovereign risk is rising, and the market may be tracing out the top of a range it may trade within over the next several years.