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"The New Economy" and the Hot Canadian Housing Market

I have made the case on a number of occasions that the Canadian real estate market, or at least parts of it, have been in a bubble.  As someone who grew up in Saskatchewan, it was mind-boggling to me to see the prices of homes in Saskatoon - a city surrounded by prairie with -40C temperatures in the winter - double in two years such that Saskatoon became a more expensive city to buy a house than any city in the United States outside of the pacific coast, New York City and Boston.

I do not often agree with the columnist Murray Dobbin, and I am not sure if I agree entirely with the conclusions in this article, but relying on a report issued by the National Bank of Canada, Dobbin argues that Canada may not be as different as America as some Canadians think.

Some have made the argument that there is no housing bubble in Canada, and that because there has not been a concurrent collapse in housing, everything is fine.

This, in my opinion, is a logical fallacy, not dissimilar to the arguments heard during the Tech Bubble, c1997-99.  The fact that a market is different or has not collapsed does not mean it is so different and will not collapse. 

US bank stocks did not look like they were in a bubble in 2006 based on any metric one looked at - current earnings, forecasted earnings, book value, tangible book value, and so on.  And they were not.  But they were dangerous investments nonetheless because the assets that supported those valuations were overvalued.

Similarly, the Canadian housing market may not look like a bubble, but the structural foundations on which those home prices are based are probably flawed.

Let us review points of the broad economy of the past 10 years, one in which most economists either dismissed or ignored.

• A tech and stock market bubble formed in the 1990s.
• The Federal Reserve pumped large amounts of liquidity in the economy to save the world from the collapse of Long-Term Capital Management in 1998 and Y2K in 1999.
• Mainstream economists focus on inflation in prices paid.  They do not focus on inflation in asset markets.  In fact, many economists believe asset bubbles cannot happen, though fewer do so today than 10 years ago I would imagine.
• The stock market bubble collapsed.
• In response, the Federal Reserve cut interest rates to 1% and held them there for a year.
• Monetary aggregates in the early part of the decade grew 20%+. 
• Central banks around the world, particularly in Asia, begin buying dollars by the trillions to avoid currency appreciation, creating a flow of liquidity into global asset markets.
• Housing prices start to rise
• Wall Street ramps up securitization, creating all sorts of derivative products and off balance sheet structures, channeling more liquidity into the financial system
• Housing prices in many countries rise three, four and even five standard deviations above long-term trends and disconnect from other valuation metrics such as price relative to rent and affordability.
• Many economists say housing is not in a bubble, and that home prices are unlikely to fall much because they haven't since the Depression, including our esteemed Fed Chairman in testimony before Congress in 2006.
• Commodity prices explode because of 1.) Structural global supply/demand imbalances, and 2.) liquidity created by central banks and asset allocation decisions by large institutions such as pension funds.  As it pertains to (2.), oil goes to $147 a barrel even as demand is dropping and supply is rising, and commodity futures markets such as oil go into almost permanent contango. (Pension funds buy further out on the futures curve to take advantage of the "roll," whereby outer-dated contracts are cheaper in backwardation and "roll" up the curve to the spot price.  Roll accounted for roughly two-thirds of commodity futures index returns from 1950 to 2000.  Everyone trying to replicate this strategy creates demand out on the curve, driving future prices up, creating contango.)
• The housing bubble pops.
• The financial markets have their worst collapse since the 1930s.
• The economy plunges into arguably the worst crisis since the Great Depression.
• The Fed drops the funds rate to 0% and supports much of the credit markets.  Government stimulus, including both monetary and fiscal policy, accounts for an unprecedented 30% of GDP.
• Asset markets, such as stocks and commodities bottom and begin to take off.

Now, let us put this into a Canadian perspective, with some unique Canadian facts.

• Canada gets its house in fiscal order in the mid-1990s, becoming arguably the best run developed country in the world after being perhaps one of the most fiscally irresponsible during the 1970s and 80s.
• The Canadian economy, which is heavily reliant on commodity prices, takes off, particularly in western Canada.  However, the strong loonie hits the manufacturing base of eastern Canada.
• Hedge funds became far more prominent in the financial markets.  With the advent of technology, they search the world to take advantage of arbitrage opportunities and carry trades.  (A carry trade is when a fund borrows in a country with a lower interest rate and lends in another country with a higher interest rate.)
• Hedge funds and other financial institutions begin to allocate more money to Canada because of the commodities boom and because of Canada's fiscal position.  The Canadian dollar, aka "the loonie" rises above par vis-a-vis the greenback and hits a multi-decade high.  
• Liquidity floods into Canada, driving up asset prices, including home prices.
• Canadian banks were not as reckless as American financial institutions.  Banking is better regulated in Canada and banks hold more capital than their American counter-parts.  Banking is essentially an oligopoly, with six banks accounting for about 80% of the market in the country.
• Because Canada's financial system is stronger, there is less forced selling of financial assets.  A "death spiral" - whereby lower financial asset prices leads to impaired capital in the banking system, which leads to more selling, which leads to lower prices, which leads to more impaired capital, which leads to more selling, and so on - is fairly absent in Canadian fixed income markets.
• Therefore, Canadian housing prices fall less than their American counterparts as capital is not as constrained.
• Governments and central banks institute enormous amounts of stimulus around the world, depreciating the value of fiat currencies and increasing the prices of real assets, including commodities.  Stimulus in China is rammed through the financial system as banks are told by Beijing to lend, leading to stock piling of raw materials in China, and higher commodity prices
• The Canadian economy is highly reliant on the United States.  Roughly 40% of the Canadian economy is dependent upon exports, and 80% of Canadian exports go to the United States. 
• The US government's and the Fed's actions are bearish for the US dollar.  The US dollar becomes the currency to finance the global carry trade.  The dollar begins to fall and the loonie begins to rise.
• In response, the Bank of Canada keeps interest rates low to offset the weakness in the US and to avoid the loonie from rising too high against the greenback, lest the strong loonie wipes out the manufacturing base of eastern Canada.
• Low interest rates spur borrowing for mortgages.  Sales of Canadian homes reaccelerate.  In some cities such as Vancouver, home sales over the past few months are breaking all-time highs.

Because both the Canadian financial system and Canadian fiscal policy are better run than in the United States, the fall-out in Canada has been less severe than in America.  Canada is a beneficiary of global liquidity creation as it lowers Canadian interest rates and keeps commodity prices strong. This liquidity is being channeled into the Canadian housing market.  Canada does not need as much stimulus as the rest of the world, but the global carry trade is channeling liquidity and capital back into the country, igniting the Canadian housing market once again.

This is very similar to what happened in the US housing market in the early part of this decade.  In 2001-03 in Silicon Valley and Manhattan, even though thousands of people were being laid off in northern California and New York City as a fall-out from the tech bubble implosion, home prices rose. There was brief dip in home prices in Silicon Valley but the massive amounts of fiscal and monetary stimulation stabilized and buoyed housing markets across America.  The Fed's policies at the beginning of the decade created vast secondary and tertiary unintended consequences, leading to the housing bubble. 

Now, in the "New Economy," where asset prices are of the utmost importance, similar distortions are being created. The fact that home sales are breaking records in some Canadian cities does not reassure me.  It frightens me.  It tells me that we have merely delayed the inevitable and are setting up for possibly worse consequences down the road, as we did at the beginning of this decade. 

There are structural reasons for higher asset prices in Canada.  However, there are still enormous imbalances in the global economies, and Canada may now be more vulnerable than most countries to the massive global liquidity creation now occurring, given that the imbalances favour commodity-based economies.

We now live in an era where governments actively support asset markets.  I dub this "The New Economy," whereby asset prices are a major input into the decision-making process by policy makers.  The enormous flood of liquidity and support by governments of asset markets is having secondary and tertiary unintended consequences, which are likely to be massive and have major ramifications in the future.  The Canadian housing market is a major benefactor of The New Economy.  The end-game is unlikely to be pretty.

No Real Estate Bubble in Canada?

Most of my focus on the bubbly Canadian real estate market has been on Western Canada.  This is primarily because over the last 10 years, Eastern Canada, i.e. everything east of Manitoba, has not much mattered in the global scheme of things as global investor demand has been focused on Western Canada, where things can be dug/mined/drilled etc. out of the ground.  It is out west where the bubbly activity in the housing market has occurred.

Worthwhile Canadian Initiative - one of my favourite economics blogs - cites data from Teranet to bolster their argument that Canadian home prices are not in a bubble.  It is an index akin to the Case-Shiller index in the US that tracks the changes in home prices in six Canadian cities - Vancouver, Calgary, Toronto, Ottawa, Montreal and Halifax.  According to the Teranet index, home prices rose 8.9% per year from 2003 through 2007 across the six cities in the index.

 

That may fast, but it is not a bubble.  So props to the economists.  There has been no bubble in all of Canada.

But there was no bubble in all stocks in the 1990s either.  Instead, there was a bubble in a select group of stocks, in particular technology and some growth and large-cap stocks.  Equal-weighted indices of stocks began peaking out at the beginning of 1998 while the bubble continued for two years. 

Thus, what is interesting is what occurs underneath the indices.  And from 2003 through 2007, home prices out west exploded.

 

Home prices doubled in Calgary and nearly doubled in Vancouver whereas they grew more slowly out east.

This is a graph scanned from Garth Turner's book, Greater Fool, of the Calgary real estate market from 1992 to 2006. (I apologize for the low quality.  Here at Running of the Bulls, you get what you pay for!)

This is what a bubble looks like.  It does not matter if the bubble is in stocks or real estate or commodities or paintings or fine wines.  When prices go unrelentingly straight up, this is almost always a sign that prices are disconnecting from fundamentals.

We also noted here and here the utter silliness of home prices in Saskatoon, where prices doubled in two years, and became a more expensive city to buy a house than most cities in the United States, even though Saskatoon is completely surrounded by farmland, is -40C for at least part of the year, and the population of Saskatchewan is about the same as it was 60 years ago.

Western Canada is where all the action has been. The demand for raw materials pushed up the value of the Canadian dollar, aka "the loonie," which was enormously positive for Western Canada but hammered the manufacturing base in Eastern Canada.  While Western Canada boomed, Eastern Canada struggled, at least relatively.

Worthwhile Canadian Initiative  posted these graphs to support their argument that home prices in Canada are rational.  I think they are wrong, at least out west, and I am going to tell you why.

First, the price of homes in the US and Canada.

They argue that if you scale house prices to gross national income, homes are not expensive.

 

They argue further that the improvement in gross national income is because of the improvement in Canada's terms of trade, i.e. the world wants more of Canada's stuff in the ground relative to what Canada wants from everyone else.  They note that half of Canada's increase in per capita income this decade has been because Canada's terms of trade improved.

There a few problems with these arguments.

First, people do not buy homes with gross national income.  They buy homes with after-tax income.  Thus, you should compare the prices of homes to household income, not gross national incomes.

I went to the Statistics Canada site to find the growth in income from 2003 to 2007, but CANSIM wanted me to pay them 36 bucks!  Well, that's not happening, so being the cheapo that I am, the free Canada Census data had growth in median income from 2000 to 2005.  For our six cities, growth in median incomes was as follows.

Halifax 2.1%

Montreal 0.4%

Ottawa 5.8%

Toronto 1.1%

Calgary 5.1%

Vancouver -3.6%

That is total growth over those five years, not per annum growth.

From 2003 through 2005, home prices rose 21.8% in Halifax, 30.5% in Montreal, 16.4% in Ottawa, 18.6% in Toronto, 24.9% in Calgary and 40.8% in Vancouver.  Thus, home prices far outstripped growth in income. 

Of course, it is not only income that matters when purchasing a home but also affordability, in particular mortgage rates and average monthly payments made by home buyers.  However, as you can see, incomes and affordability would have had to double in the western cities in 2006 and 2007 for incomes to keep up with the prices of homes, and that did not happen.

The other potential flaw in logic in their argument is assuming that changes in the products driving improvements in the terms of trade are rational.  Since Canada's terms of trade were driven by increased prices in commodities, the question becomes whether or not the changes in commodity prices are rational?  

This is far from clear.  Certainly, some of the price moves are rational.  With the inclusion of China, India, Brazil, et. al. into the global economy, along with supply bottlenecks, there has been a structural shift upwards in the global price curves of most commodities.  But how much of rising commodity prices is due to structural shifts and how much is due to speculation is unclear. 

Was oil at $147 rational?  Today, oil has more than doubled in four months to $70 yet inventories are at 20 year highs.  Is it rational for oil to be at $70?  Maybe, if the recovery absorbs all the excess inventory, but without a doubt, financial market speculation has and is playing a significant factor.

This is an important concept to understand - If the underlying security is being supported by an asset bubble itself, even if the security appears fairly priced, then the underlying security itself is in a  bubble. 

For example, financial stocks did not look expensive in 2006 based on current earnings.  However, earnings were based on asset markets which were egregiously over-valued.  Thus, when home prices collapsed, so did the earnings of the financial companies.  Financial stocks were very over-valued because the true profitability was overstated by the bubble in home prices.

Likewise, if Canadian home prices appear fairly valued based on incomes while commodity prices are over-valued, the country's terms of trade are skewed and underlying incomes supporting home prices are too high.  If, for example, the structural long-term average of the price of oil is $50, the terms of trade for Canada will decline, incomes will decline (or grow slowly) and home prices are currently too high.

Reasons to be Bullish

Frankly, I am having a hard time being bullish because everything feels so bad.

I was in the office on President's Day and watched the S&P 500 futures tick down to near-term support at 806, such that futures are indicating a 20 point decline at the open on Tuesday.  Now, it appears the market has formed a short-term double-top, and with stocks continuing to reach lower highs, it feels like we are about to break to the downside and re-test the November lows.

Emotionally, selling feels like the right thing to do.  However, cerebrally, since I have a time frame longer than my nose, there are many reasons not to sell at these levels, and to in fact buy stocks.  But it is difficult not to walk away in disgust, especially after last week's action, which was just horrible.

Everyone knows why you should be bearish - the credit crunch continues, the economy is terrible and earnings estimates continue to come down.  The reasons to hate stocks are very well known.  So I made a list of reasons why stocks could be substantially higher within the next year or so.

• Credit spreads have improved.  Credit remains tight, but spreads have come in.  Over the past 50 years, the average gain to stocks has been 18% when credit spreads are falling.

 

• Cash spreads are improving.  The TED spread and swap spreads are at levels last seen before the crisis began last fall.
• Treasuries are backing up and yields are rising.  The bond market has experienced a violent sell-off in the long end of the curve, while short-term T-bills - which were yielding negative returns a few months ago - have seen rising yields.
• The yield curve is steep.  When the curve is this steep, it almost always signal economic expansion over the next 12 months.
• Corporations issued the highest volume of debt in January than in any month since May.  In fact, debt issuance was greater than the last four months of 2008 combined.
• The dollar may be topping.  Some may argue that this is because of all the debt that the Treasury will flood onto the market.  However, a rising dollar has also been indicative of fear and a flight to safety.  A falling dollar may indicate that fear is seeping out of the market.

• The euro/yen cross has been moving sideways for months and may be basing.  The euro/yen carry trade had been popular over the past several years as investors bought higher-yielding euro-denominated bonds and financed the purchases by borrowing in lower-yielding yen.  This carry trade has been seen as a proxy for risk appetite in the global capital markets.  It may be signaling that investors are becoming less fearful.

• The gold/silver ratio has fallen below 70.  The ratio was as high as 80 a few months ago.  Both gold and silver have been rising the past few months, but silver has been rising faster than gold.  From September through November, silver fell 30% to the trough whereas gold fell 10%.  Silver is a thinner market but it is also an industrial metal and more exposed to the general economy than gold.  Gold is a haven during crises.  Silver prices rising faster than gold prices may be signaling that the economy is going to get better in the future and/or investors are less fearful about financial markets.
• Metal prices may be bottoming. Though it is still early, a bottom in stocks is sometimes presaged by a bottom in metals and commodity prices. 
• Commodities may be bottoming.  Oil may be putting in a bottom as well.

 

• Canadian stocks may be bottoming.  Energy and metals comprise roughly half of the total market capitalization of the Toronto Stock Exchange.  Materials stocks in Canada have been performing fairly well.

• Chinese stocks may be bottoming.  Stocks in China have been acting well as of late.  I am long the FXI.

• Semiconductor stocks have been outperforming and may be in the beginning of an uptrend.  Semiconductors are often an early indicator of the health of the technology industry.  I am long a basket of semiconductor and semiconductor equipment stocks.

• The VIX is acting like it wants to break below 40.  On Thursday's intra-day reversal, the VIX closed sharply down.  On Friday, when the market sold off during the last 20 minutes of the day, the VIX gave up less than half the decline of the prior session.  This may be a sign that investors are getting more confident of the future.

• Asset allocation by individuals towards equities is at or near all-time lows whereas allocations towards cash is at or near all-time highs.  The public is generally positioned like this at bottoms.
• Cash levels are at multi-decade highs.  There is nearly $9 trillion in cash on the sidelines currently.
• Hedge funds are heavily in cash.  There are very few hedge funds that are bullish now.
• Private equity investors are sitting on their hands.  After incurring large losses in their portfolios and wary of the cash crunch of their limited partners, private equity funds are doing little.  It seems that everyone is waiting for a turn before investing.
• Everybody whom I talk to is negative.  I have had in depth discussions with two dozen highly knowledgeable investors this month, and they are all overwhelmingly and uniformly bearish.  Every.  Single.  One.  Even those who are buying because they see value in the market are bearish on the market and the economy as a whole.  I had to talk a friend and a 20-year veteran of the business off the proverbial window ledge last week.
• Reversion to the mean suggests at least a bounce.  Last year was one of the worst years on record.  Tremendous selling usually begets a significant rally.
• Stocks are cheap.  Whether you want to measure by the 10-year moving average of earnings, Tobin's Q, or measures of book, sales and normalized earnings, stocks are inexpensive.

Now, as I tell you all this, I think there is a fairly good chance - 60% or 70% perhaps - that the market is about to re-test the lows over the next week or two.

Even after I listed all those points above, I cannot tell you that I feel bullish.

Maybe that is a sign a bottom is near.

Canadian Banks Performing Relatively Well

Canada's banks are performing pretty well.

The World Economic Forum says Canada’s banks are the soundest because they speculated less on mortgage assets that have proved toxic. Canada’s banks, which account for about 6.7 percent of the industry’s worldwide market value, suffered only 1.5 percent of the $817 billion in mortgage-related losses reported globally.

As Canada’s banks wrote down $12.5 billion since 2007, its six biggest lenders, including Royal Bank of Canada and Toronto- Dominion Bank, attracted new investment, selling C$9.2 billion in stock and bonds as a group since October.

Unlike their global counterparts, which have accepted almost $500 billion in bailouts, Canada’s banks have done without direct government aid. While Canada is providing guarantees on more than C$200 billion in bank debt and has bought mortgage bonds to boost lending, none have required taxpayer-funded cash injections.

“There is a sense that the Canadian banks are much better regulated and in stronger shape,” said Quincy Krosby, Hartford, Connecticut-based chief investment strategist at Hartford Financial Services Group Inc. The firm has $346 billion in assets. “The Canadian market has come on the radar screen over the last month or so.”

At least so far.  Home prices have only begun to fall in Canada and have some ways to go. 

Canadian Budget Deficits

In response to the worsening economic crisis, Canadian Prime Minister Stephen Harper has introduced a budget that will generate a deficit of $40 billion next fiscal year, the first time the budget will not be in surplus in 12 years.

Here is an interactive feature from The Globe and Mail on the contemporary history of Canadian fiscal balances.

The question now is whether or not the Liberal Party will vote against the budget, sending the minority Conservatives to defeat and perhaps triggering the second federal election in Canada within six months.

The Banana Republic of Newfoundland

Hugo Chavez ain't got nothin' on Newfoundland and Labrador premier, Danny Williams.  Ol' Hugh at least pays compensation for expropriating private assets owned by corporations, unlike Williams, who is just taking the assets of forestry company AbitibiBowater.

AbitibiBowater is threatening legal action under the North American Free Trade Agreement over Newfoundland and Labrador's move to expropriate its resource rights and hydro assets in Grand Falls-Windsor ...

“The legislation is an entirely unfounded and unscrupulous attack by the province of Newfoundland and Labrador,” it says.

“The legislation, which is without precedent in Canada, and is reminiscent of decrees emanating from jurisdictions with less democratic traditions, shocks common sensibility.”

The province hastily passed Bill 75 on Tuesday to expropriate the company's hydroelectric assets, water and timber rights in the Grand Falls-Windsor area.

The move came after Montreal-based AbitibiBowater announced it was shutting down a century-old mill in the central Newfoundland region, with the loss of nearly 800 jobs.

The company says its legal advice is that the expropriation is “clearly and unequivocally” illegal under NAFTA and international legal principles.

“While the government of Newfoundland and Labrador appears to wish to punish AbitibiBowater Inc. for the announced closure of the Grand Falls mill, it is the people of Newfoundland and Labrador that stand to suffer from the clear signal being sent by the government that private property rights and the rule of law in the province are expendable,” says the letter, which is copied to the Justice Department in Ottawa.

The law passed by the legislature says all of AbitibiBowater's assets except for its pulp and paper mill will be owned by Nalcor, a recently established provincial Crown corporation. Those assets include dams and power stations. ...

Mr. Williams has said AbitibiBowater broke a century-old “covenant” with the province when it decided to shut down the mill next March, a move that would devastate the Grand Falls-Windsor economy. He pointed to a 1905 agreement that gives AbitibiBowater access to wood and hydroelectricity as long as it runs a milling and logging operation.

Mr. Williams said the government will not compensate AbitibiBowater for the loss of water and timber rights.

Scratch Newfoundland off the list of places to invest.

Canadian Real Estate Prices Plummet

I have been amazed at the denial of many of my fellow Canadians regarding sky high home prices, which we have been flagging for some time, here, here, here, here, and here.

Now, the inevitable has happened and real estate prices in Canada have fallen 10% from last year, more in the hotter areas such as Vancouver.  

West Vancouver builder Sean Hanley thought Canada's real estate market would be immune to the housing recession that sent values tumbling in the U.S. Then the economy slowed and oil prices fell.

The price of a detached house in this upscale community fell 22 percent in October from a year earlier, helping to drag the average residential price in Canada down by 9.9 percent, the biggest decline in 26 years, according to the Real Estate Board of Greater Vancouver and the Canadian Real Estate Association. For Hanley, that's meant nary a buyer for his five-bedroom home. ...

``It's been a shock for some people,'' Peacock, 42, said in an interview. ``They sort of embraced the idea that we had a strong domestic economy and we would be insulated.'' ...

``Canada's housing market seems to be tracking the U.S. with a two-year lag,'' said David Wolf, a Toronto-based economist with Merrill Lynch & Co.

No kidding.

The Loonie and Oil

From Worthwhile Canadian Initiative.  The movement in the Canadian dollar was highly correlated to the movement in the price of oil.

Conservatives Win Minority Government

Prime Minister Stephen Harper and the Conservative Party have won a minority government in the Canadian general election this evening, albeit with a larger caucus than when Parliament was dissolved.  The Tories will head to Otttawa with 144 Members of Parliament.  There are 308 ridings in the Canadian House of Commons. A party must win 155 seats to win a majority. 

There was a possibility at the beginning of the election that Harper might win a majority but the odds were long. The Conservatives slipped as polling day drew near, and there were projections that Harper might win around the same number of seats - 127 - the Tories held before the writ was dropped.  However, the Tories did a bit better than expected today while the opposition Liberals did worse, giving the Conservatives a workable minority.

The main challenger to the Conservatives was the Liberal Party.  The main plank of the Liberals was their so-called Green Shift, which would have raised taxes on the energy industry offset by lower taxes elsewhere.  This would have hurt Canadian stocks as about 30% of the Canadian market is comprised of energy companies.  Thus, Harper's re-election with a stronger mandate is positive for Canadian stocks and the Canadian dollar, aka the "loonie."

Canada, World's Soundest Banks. America, 40th, Behind Namibia.

From the World Economic Forum.

Canada has the world's soundest banking system, closely followed by Sweden, Luxembourg and Australia, a survey by the World Economic Forum has found as financial crisis and bank failures shake world markets.

But Britain, which once ranked in the top five, has slipped to 44th place behind El Salvador and Peru, after a 50 billion pound ($86.5 billion) pledge this week by the government to bolster bank balance sheets.

The United States, where some of Wall Street's biggest financial names have collapsed in recent weeks, rated only 40, just behind Germany at 39, and smaller states such as Barbados, Estonia and even Namibia, in southern Africa.