Putting your Assets on the Line
Millions of Americans have been viewing their humble abodes as their own, personal ATM. Marc Faber looks at this phenomenon and wonders when people will realize that they shouldn’t have everything riding on their household assets…
Let us assume that a family lives in the same house today as they did 30 years ago. The house has certainly appreciated in value, but it is nevertheless the same house. As a result of the price appreciation, the standard of living of the family hasn’t improved unless it leveraged the house and used the proceeds for some profitable investments. (Note that buying a more luxurious car is likely to be only a temporary standard of living improvement, unless home prices rise constantly at a faster clip than the CPI – which is not very likely.) Furthermore, property taxes and maintenance costs on the house would have risen considerably over the last 30 years. Now, let us also assume that a family that has held a house since the mid-1970s sells their property. This family will now have to rent or buy a new house. The rental fee or price of the new home; provided it is similar in size and location to the family’s original home, will also have increased significantly over the same period.
Therefore, it is difficult to argue that this family is any richer, based on housing price inflation alone, than it was 30 years ago. Only if that family decided to move from, say, San Diego or the San Francisco Bay area to the Midwest or somewhere in Africa or Southeast Asia would it have realized a true, but nevertheless inflationary, gain. Moreover, whereas the household’s sector wealth has risen, so have the system’s overall debts.
In 1975, total domestic non-financial debts amounted to $2.26 trillion, and for the year total non-financial debt grew by $192.7 billion. In 2004, total non-financial debt reached $23 trillion, and annual non-financial borrowings are running at an annual rate of around $1.8 trillion. (Household total debt as a percentage of personal income has risen from 60% in 1975 to 120% at present.) In the meantime, total debts (including financial borrowings) have increased from 120% of GDP to more than 300% of GDP, while, the U.S. net international investment position has collapsed from around 10% of GDP to -25% of GDP in 2004.
Housing Price Inflation: What’s To Worry About?
But hey, what is there to worry about?! The deterioration in the net investment position of the United States is due to the current account deficit, which, according to the outgoing chief economic advisor to the president, Greg Mankiw (also a Harvard professor), to some extent "reflects the fact that the United States is growing much faster than the rest of the world…Our demand for their goods has been growing more rapidly than their demand for ours."
I am a director of a company. When I ask questions at board meetings, the chairman of the company occasionally responds by saying first that my question is the stupidest he has ever heard in his life. I am greatly relieved, therefore, that the chief economic advisor to the president also makes really bizarre (to put it politely) statements, since it should be obvious to anyone that Asia ex Japan, a region that has economic growth rates around twice that of the United States (and not driven by debt and asset inflation), actually has rising trade and current account surpluses with the United States. But the point here is, although household assets have increased considerably since the mid-1970s, I cannot shake the impression that, based on the rise in debts, the horrendous and deteriorating net investment position, and the unfunded social security, health, and pension fund liabilities, the United States as an economic system is actually poorer today than it was 30 years ago.
But let us look at another aspect of the inflated asset values. What caught my attention was a recent piece by Byron Wien in the December issue of U.S Strategy, "The Inflection Point," in which he discusses how, over the past 50 years, the United States went from being an economic, scientific, political, and military leader "to something less powerful."
Symptomatic of this shift, he writes, "When I got out of college a half-century ago, it was easy to find a job and only true incompetents got fired. The concept of downsizing was essentially unknown. We all wanted to prove our independence, and the way to do that was to take no money from your family. Today many college graduates have a tough time finding the job they want. When they do, it rarely pays enough to live as they would like to. Most have no qualms about getting family help or drawing on a trust fund if they have one.
"Some lose their jobs for various reasons and some are out of work for years. With houses and apartments suitable for a family in and around many urban areas costing high six-figure sums, many cannot consider home ownership without family support. As a friend put it, ‘My children are in their forties and I am still part of their lives emotionally and financially.’"
Wien’s piece struck a chord with me. For one, I have a daughter who is studying psychology. I am convinced that the income she will earn from this career won’t allow her to enjoy the same lifestyle that I have enjoyed. But not only that! If I compare my lifestyle with that which my grandparents and father enjoyed, then it would be difficult for me to make the case that my lifestyle is far better than theirs was, even though my assets are worth far more than they ever possessed. Of one thing I am sure, however. In the homes of my grandparents and parents, we ate superb food. By ten o’clock each morning, my grandmother would already be in the kitchen with her full-time housekeeper, where the two of them would essentially spend the whole day cooking. (My grandparents weren’t even "rich" people, but upper middle class.)
When I compare the food I ate at my family’s table with the food I usually eat in hotels, restaurants, and private homes in the United States, I am convinced that at least the quality of my culinary lifestyle has plummeted. In fact, were I to live in Switzerland, I’m not sure that I would be able to afford my late parents’ lifestyle. I might add that most of my friends from school also have a more modest lifestyle than their parents enjoyed, unless they had the good fortune to inherit substantial assets. The point is simply that income gains have lagged asset inflation, and that housing affordability for first-time homebuyers with a median income has become an issue. And this is the case not just in the United States, but also in Western European countries! In respect of this, one of my readers, Mike Buchsbaum, sent us an interesting comment:
Housing Price Inflation: The Homebuyer Gap Index
"When Greenspan takes the stage today [February 17], he will fail to mention the following disconnect. On Tuesday, the California Association of Realtors discussed the homebuyer income gap index. California households, with a median household income of $53,240, are $56,070 short of the $109,320 qualifying income needed to purchase a median priced home at $470,920 in the state. [In 2001, the median U.S. family’s pretax income was $39,900] The realtors’ homebuyer income gap index for California increased 41.6% during the fourth quarter of 2004 compared to the fourth quarter of 2003, when the gap stood at $39,610, the median household income was $51,860, and qualifying income needed to purchase a median-priced home at $390,250 was $91,460. At $84,690 the San Francisco Bay Area had the highest gap in the state since potential homebuyers had, in 2004, a median household income of $67,750 but needed qualifying income of $152,440 to purchase a median-priced home at $656,690."
It only gets better in 2005. In January, home prices in the San Francisco Bay Area soared 20% from a year ago and sales reached the highest level for the month since 1989. Specifically, in San Francisco, a typical single-family home increased in price to $713,000, a 23% rise from last January’s $580,000. The typical Bay Area buyer committed to a monthly mortgage payment of $2,344 in January, up from $1,940 one year ago.
According to DataQuick’s research, which is based on filings with county recorders’ offices, the median price for a single-family home has hit a record in nine of the past twelve months. Around San Francisco, there are nine Bay Area counties. Let’s see what Greenspan’s record low interest rate and accommodative policy helped produce from January 2002 to January 2005. Keep in mind that the recession ended in November 2001. The monthly median single-family home price for the nine Bay Area counties was $380,000 in January 2002; $415,000 in 2003; $463,000 in 2004; and $556,000 in January 2005.
That’s only part of the story. Essentially, there have not been any price declines during these four years. In many cases, little or no money was put down on these homes. The return on investment has made the Dow, NASDAQ, and the S&P 500 look like junkyard dogs. It gets better. As the price of the home increased, more borrowing against the value of the home was possible. Hence, establishing one’s home as an ATM!
for The Daily Reckoning
March 23, 2005 — London, England
Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and author of Tomorrow’s Gold, one of the best investment books on the market.
Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has long specialized in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.
Dr. Faber is a regular contributor to Strategic Investment.
Greenspan took another "baby step" yesterday – his 7th little stride towards "normalization."
"Stocks fade on inflation worries,’ reported CNNMoney.
The Dow is falling. So we ask the familiar question: Is this the beginning of what must be? Or is it merely the continuation of what has been? Is it the future or the past?
Is. Was. Will be again. If things remained the same there would be no need for verb tenses. But things do not remain the same. They change.
But after a long while of remaining the same, investors begin to underprice change. A speculator can make money, we believe, by consistently betting against the present tense. Not always. Not when the present tense only came into play recently. For then, investors still price things based on the past. But after a long spell, investors begin to believe that that which is will be forever. They make their bets on a false premise…underpricing risk, underpricing change…and overpricing stability.
An investor today, for example, is likely to believe that major Dow stocks almost always go up – over the long run. Thus, if he takes a long view, he will see little risk in buying today, or any day. This attitude, this faith in the present tense, leads to a speculative opportunity. For the average investor has come to believe something that isn’t true. He has placed his bet inappropriately, unwisely paying too much for stocks in the mistaken assumption that they pose little risk to him. The shrewd speculator has no more idea of whether stocks will go up or down than the naïve punter. But he knows that the lumpen have miscalculated the odds, so he will take the other side of the trade. Naïve players may be right – maybe stocks do usually go up. Still, they have paid too much and now the odds favor the short side.
We are having lunch with Nassim Nicholas Taleb on Friday. We’re going to put the question to him. Taleb wrote the excellent book, "Fooled by Randomness." We were so impressed, we decided to translate it into French and publish it in Paris. Taleb is a mathematician. His point is that investors misapprehend the randomness of events. They see a fund manager who has done very well for five years in a row…and they buy his fund. They don’t realize that his performance may be purely a feature of randomness – pure chance, in other words. Out of a group of thousands of funds, some are going to produce spectacular results. Most likely, the results are nothing more than chance. But investors’ misperceptions create a speculative opportunity.
It is as if they had watched a group of men flip a coin. Out of a group of ten flippers, one gets heads ten times in a row. Normally, the odds of getting heads would be only 50/50. But this man, they believe, has a talent for flipping heads. So, they bet on heads again – not at 50/50 odds, but at 60/40 odds. To win a dollar, they must pony up 60 cents.
The speculator spots his opportunity. He realizes that the man has flipped heads 10 times in row purely by chance…and that his odds of getting heads again are still only 50/50. No one has any idea whether heads will come up or not, but the clever speculator knows that he must best against it – because the odds favor him.
Over the broad sweep of stock market history, prices have gone up. From barely 100 following the crash of ’29, the Dow is now over 10,000. Who can doubt that the tendency is up? Yet, adjusted for consumer price inflation, the Dow is only about 500. And most of that increase is merely cyclical. A dollar of stock-market earnings is sometimes judged to be worth only $5 or $6 of capital investment. Other times, investors are willing to pay more than $20. At any particular time, a speculator may have no idea whether stocks are headed up or down. But he knows that they are likely to overprice the present tense. After having marched from under 1,000 to over 10,000, from 1982 to 2005, investors have come to believe the tendency is definitely up. Over time, the likelihood that stocks will be relatively "cheap" or relatively "expensive" is about 50/50. But today’s naïve buyers think they’ve come across someone who flips heads every time; they expect stocks will become even more expensive than they are now. They’ve made their bets accordingly – which is reflected in stocks’ current prices.
We do not doubt that they will be wrong. But when "is" turns to "was" is for the gods to decide. They will let us know, of course, but not in advance.
More news, from our team at The Rude Awakening…
Tom Dyson, reporting from rainy, dreary Baltimore:
"How can the banking sector continue to be so profitable when – for the last few years – M&A has been flat and the IPO market dry? We think we might have the answer…"
Bill Bonner, back in London…
*** Interest rates approach the inflation rate, which approaches the rate of GDP growth, which is only half the rate of increase in the money supply! The feds may say they are "normalizing," but they are taking no chances. They have to keep the money flowing – at least until after Mr. Greenspan leaves his post next January.
The world needs money, lots of it. Liquidity is mother’s milk to a fragile company like GM. It owes $300 billion – with $16.5 billion in payments coming up this year. Meanwhile, Fitch and Moody’s have just downgraded GM’s credit rating to nearly "junk" status. Amazingly, the company can still borrow at only 578 basis points – better than a residential mortgage. According to today’s reports, GM is in no immediate danger. It has almost $50 billion in cash and other credit lines of $70 billion. But imagine if General Motors had to borrow at 1,000 basis points. Ooh la la…we wouldn’t want to be entering retirement, expecting to clip GM coupons for the rest of our lives…
*** Dan Denning on the Fed’s quarter point rate hike yesterday…
"The Fed funds rate is not the only one that’s rising. The Mortgage Bankers Association reported that its gauge of mortgage applications fell 9.5% last week. Thirty-year rates are now just shy of 6%. As Marc Faber wrote in yesterday’s Whiskey and Gunpowder, ‘In a leveraged system, even small interest rate increases can have a meaningful impact on asset markets. We would avoid homebuilding stocks and are looking to short them.’ (More from Dr. Faber below…)
"In point of fact, Lennar (LEN) has fallen 11% since late February. The Philly Homebuilder’s Index (HGX), is down 7% from its all-time high at 518. And our girl Fannie Mae (FNM), the queen of the mortgage lenders and the pin up girl for the housing boom, continues her year-to-date nervous breakdown, off nearly 24% for the year and sulking at $54."
*** A reader writes:
"First, thank you for your column. It is really entertaining and has helped me enormously to understand how the financial world works…or doesn’t, as seems to be the case in the English speaking world at the moment. Like you, I am mystified as to why the U.S economy has not crashed yet. Here in Australia we seem to be following the same crazy path as America, consuming Chinese-made goods on the strength of our ever increasing house prices – although they have slowed recently.
"Anyway, here’s my question: What would happen if the Chinese (and all the other Asian nations holding huge quantities of the U.S. dollar) started to use all of their U.S dollars to buy commercial and residential property in America? Would this not:
"1. Cause property prices to rise even further, thus prolonging the boom and allowing Americans to consume even more Chinese goods, thus giving the Chinese even more money that the Fed would be creating at an even greater rate, ad infinitum…
"2. Ultimately result in the Chinese owning a huge percentage of America (if I remember correctly the Japanese were doing this 15 years ago – but with borrowed money from their property boom) – and they wouldn’t even have to go to war to take over the country.
"Surely, this is win-win strategy for the Chinese because it keeps the boom going with their goods being consumed and when the bust finally comes they’ll own America?
"Is there any flaw in this reasoning?"
Our response: Currently, the Chinese make about $200 billion per year trading with America. That is the measure of America’s trade deficit with the Chinese. This amount is growing by 30% per year. In a five-year period, you could expect the Chinese to have about $1 trillion worth of dollar assets. If this kept up for 25 years – the Chinese could own 10% of the entire country.
[Ed. Note: China will most likely win the economic war that they are waging…and 50 years into the future, after feeding off of our minerals, oil and other natural resources, they will be the richest and most powerful nation in the world. This economic takeover will be disastrous for everyone – but you can still come out unscathed – if you "China proof" your money.