Waiving the Warning Flags

The Daily Reckoning PRESENTS: Hindsight is always 20/20, and the same goes with economic bubbles. Most don’t realize that the bubble exists until it is too late – not unlike what we are experiencing right now with the U.S. housing market. Puru Saxena gives us a closer look…


The eternal truth in the investment world is that every asset class goes through boom and bust cycles, which typically last for several years. However, it is ironic that toward the end of any bull-market, when the risk is extreme, optimism toward the booming asset-class is usually at a record-high. On the other hand, during the final phase of a bear-market, when the downside risk is limited, the asset that is selling at a huge discount is always neglected and hated by the public. The reason for this irrational behavior is that most people find it hard to foresee and accept change. The conditions that have been prevalent for a long time are considered to be permanent, and investment decisions are made accordingly.

In the late 1990’s, the entire world was in love with the “new era,” which was inspired by technology. Fund managers, economists, media commentators and even the shoeshine boys were drooling over the prospects of retiring young, thanks to their Microsoft and Intel shares. Of course, that turned out to be the worst time to be invested in the hype as the technology shares came crashing down to earth in March 2000. Back then, I recognized that commodities were on the bargain table relative to financial assets. Therefore, I started buying precious metals, but most people thought that the “Millennium Bug” had infected me.

“Why are you buying gold? I lost a lot of money in gold 15 to 20 years ago and I’ll never touch it again,” were comments I often heard. Once again, the great majority failed to identify change, thereby ignoring the birth of a new bull-market.

Once the great technology bubble burst and the United States slipped into a recession, the central bankers decided to fight the slump by lowering interest rates to a multi-decade low. In the United States, interest rates were pulled down to a miniscule one percent. As the cost of borrowing came down, Americans turned to real estate as the next sure thing. Real estate prices surged, as demand rose due to cheap and abundant credit. As home prices continued to rise, Americans started using their real estate as collateral to borrow money.

Falling interest-rates and appreciating home values also created an explosion in re-financing activity and the United States embarked on a gigantic spending spree. It is worth noting that over the recent years, Americans have extracted a ridiculous amount of equity from their homes. In fact, since the beginning of this decade – 4.6 trillion U.S. dollars! To make matters worse, the negative personal savings rate in the United States highlights the fact that these loans taken out against homes weren’t saved for the proverbial rainy day; instead the money was spent on consumption.

This recklessness has put the U.S. economy in a precarious situation. Interest rates are now rising all over the world. After a multi-month pause, I expect interest rates to continue their upward trend. So far, the Federal Reserve has raised rates 17 times to 5.25% and the impact is already being felt on American real estate. I’m afraid the property industry in the United States is falling into a serious recession. In June, new home sales fell to 1.49 million units, the lowest since November 2004. It’s down 18.1% from the record-high of 1.81 million units during January 2006. Furthermore, the supply of U.S. homes for sale has recently jumped to a multi-decade high. In summary, rising-interest rates are starting to bite into the real estate boom and trouble may be on the horizon.

I’ve been warning about housing for several months now and still urge you to get rid of your investment properties. In my opinion, we are in the final stages of the housing boom and once again, the majority of people can’t foresee this change. The warning flags are everywhere! Recently, the stocks of major U.S. homebuilding companies declined sharply and I consider this an ominous development.

The S&P 500 Homebuilding Index is down 46.2% from its July 2005 record high! Such a major sell off in this sector is the market’s way of forecasting deteriorating business conditions ahead in the real estate industry. Moreover, if U.S. housing slips into a recession and prices decline, consumption will also be badly hurt due an abrupt ending of the refinancing boom. Remember, consumption accounts for roughly 70% of GDP growth in the United States and any slowdown in this department may send its entire economy into a recession.

Furthermore, it is my observation that apart from the United States, real estate is generally overvalued in the majority of nations. Due to poor wage growth and rising interest rates, housing simply isn’t affordable anymore. It may deflate over the coming months as demand continues to evaporate. So, to reiterate, my sincere advice to you is to liquidate your leveraged properties and invest in the world of natural resources where the bull market is still in its infancy! A mega change is currently underway and over the coming years, I envisage major capital flows from financial assets to commodities.

In my view, every investor must allocate 20% to 25% of his or her total net-worth to precious metals. This may sound extreme, but in a world where central bankers continue to inflate the supply of money, gold and other precious metals offer the best wealth protection.

Over the coming years, I expect the various central banks to print a ridiculous amount of money. The United States faces a $46 trillion debt monster and the only way it can remain solvent and pay off its debt is through monetary inflation. Remember, the easiest way to repay debt is by diluting the purchasing power of each unit of money. So, through monetary inflation, the 46 trillion dollars the U.S. owes today may not “feel” like $46 trillion in 10 years time! To complicate matters further, due to globalization and international trade, no country wants a strong currency.

So, if every nation continues to print money in order to keep its own currency weak against a fundamentally weak U.S. dollar, the entire basket of “paper” currencies will decline against precious metals – the supply of which can’t be increased ad infinitum.

Precious metals are in a gigantic bull market, which is likely to continue for as long as monetary inflation remains the norm. For sure, no bull market continues to rise forever, and each boom is punctuated with multi-month consolidations. After a stellar multi-month surge, the precious metals bull market witnessed a vicious yet normal pullback in May.

In my opinion, the worst is behind us now and this is an ideal time to add to your positions in precious metals. After a few more weeks of consolidation, I anticipate another strong advance over the coming six to nine months. The rising geo-political tensions and a possible conflict between the United States and Iran may cause precious metals to really shine in the period ahead.

Back in 1980, on an inflation-adjusted basis, gold peaked at $2,100 per ounce and silver peaked above $100 per ounce. Today, you can buy gold at $630 per ounce and silver at $12.5 per ounce – absolute bargains, given the money and credit growth we’ve seen over the past 26 years!


Puru Saxena
for The Daily Reckoning
August 24, 2006

Editor’s Note: Puru Saxena is the editor and publisher of Money Matters, an economic and financial publication available at www.purusaxena.com

An investment adviser based in Hong Kong, he is a regular guest on CNN, BBC World, CNBC, Bloomberg TV & Radio, NDTV, RTHK Radio 3 and writes for several newspapers and financial journals.

“Strapped homeowners feel the pain,” observes a Wall Street Journal headline.

The pain these homeowners feel is, of course, the pain they richly deserve. They took out mortgages with low teaser rates…and now their rates are being adjusted upwards. And they are being squeezed.

The article tells of one couple whose mortgage jumped from a 2.35% rate to 8.75%, two years later. They had something called an “Option ARM,” which gave them a selection of alternatives. But now they find they have no alternative at all – they cannot afford their own home and must sell the thing. They and every one else, apparently. The market is flooded with inventory. Sellers are getting soaked. The homeowners mentioned in the article put their house on the market for $400,000. With no bids coming, they’ve cut the price down to $270,000. They have no choice; they can’t afford to keep the house.

And there are plenty more facing the same dilemma. Delinquency rates are rising, led by delinquencies on ARMs that are three times the rate of regular, fixed-rate mortgages.

Our heart is not breaking. But we are nevertheless appalled by the shabby way the poor chumps are treated. They are regarded not only as fools who blundered and deserve to be separated from their money (they didn’t have any anyway), but now they are also losing their homes.

When we left you yesterday to go gallivanting around France – on business, alas – we were expostulating on the idiocy of the professors of “Behavioral Finance.” They think they are being investment “descriptivists,” who merely tell us what people actually do. But they can’t seem to resist being “prescriptivists” – telling people what they should be doing if they want to maximize their investment returns.

And, when the investor doesn’t do as they say he should, he is accused of making “mistakes.” Yes, of course, the average investor does things that seem stupid to the analyst. But the deeper mistake is the one made by the analysts themselves. They misjudge their subject. He is not a rational profit maximizer at all; he is merely a man.

If he chooses a stock because he likes the sound of the name or because his neighbor told him it will go up…so what? It might go up. And so what if it goes down? He might have taken the money and bought something – but what? Why is buying a new car, a big-screen TV, or even a few dozen pills better than buying a stock? They are all consumer junk, one way or other. All of them break down, go down, wear down and eventually disappear as completely as any dotcom.

On the other hand, buying a tech stock, for example, the lump at least has the pleasure of momentarily strutting around like a cross between Livermore and Lynch. Who knows, the darn thing may go even further up…and make him feel like the one of the gods themselves. And if it goes down, at least he has learned something valuable. Something that is worth more than staring at a TV screen or smogging up the ozone in a fancy car, we think.

The big error made by the Behavioral Finance professors, economists, investors, and consumers themselves – is that they overrate the value of money. They think money is everything.

But just a few days ago, we had a taste of its limitations.

“I was shocked,” Elizabeth announced upon returning from a trip to visit friends. “They spent all that money and the place is just not very attractive. The stables are well built, but they are just badly designed. And the house is nothing to get excited about. They are too close to the highway, and they have a view of the power lines. I know they invested millions in the place. And I know why they bought that place rather than something else. They thought it was a better buy; it was cheaper. Now I know why. It’s not very nice. And it’s not very nice for reasons that they can’t do anything about.”

Money is not everything. In their hearts and souls, people know it…and they devise financial strategies that take it into account, often “wasting” money or failing to maximize revenue. And, they probably make as many blunders by focusing too much on money as they do by ignoring it.

And yet, economists build their theories around a man who only cares about money. Thank god, he does not exist.

The poor sap who does makes plenty of “mistakes,” of course, buys houses tangled in power lines, and takes out an ARM to save money. But the Adjustable Rate Mortgage is more than a “mistake.” And the poor man who got one – without fully understanding what he was getting himself into – is more than just a fool.

Now, everyone knows that the housing market is coming down. And everyone knows that all those chumps with ARMs are paying through the nose and getting it in the neck. Investors have convinced themselves that the great property boom is floating down to a soft landing. They look at England and Australia, for example, and say, “Look, both had residential real estate booms bigger than in the United States. Both have seen prices come down. But neither has had any real problems as a result.”

But in England, the day of reckoning for property prices is yet to arrive, for prices have been propped up by huge waves of foreign money pouring into London. And in Australia, the economy was only saved by the boom in commodities. What will save the U.S. economy? What will save all the marginal investors, homeowners, and consumers who have chained themselves to the ship of rising property prices?

We have a guess: America will not be so lucky. Our property market will come down in the biggest, hardest landing ever. Homeowners and consumers have so much debt, that when the ship goes down, they will drown in it.

But whom should we blame? Are the luckless home owners willing victims of their own “mistakes?” Or of what? More to come…much more, tomorrow.

More commentary over at the Desidooru Saloon…


Justice Litle has the latest post:

“It’s as if some marketing genius said, ‘Hmm, what percentage of Forbes’ readership is career-oriented women…and how could we get them to cancel all at once…'”


More thoughts from Bill and Addison …

*** Bill in Ouzilly:

Yesterday, we rushed from one difficult meeting to another. What kind of vacation is this, we wondered? The only sign we were holidaying was that we were not wearing a tie.

Vacations are trying for us, dear reader, because we don’t like to leave you. Usually, we try to work and vacation at the same time, which means we try to do twice as much as we do during the regular workweek.

Will you forgive us is we take the rest of the day off?

*** Over to Addison:

In the United States, we have witnessed – through statistical manipulation and public cheerleading – a symptomatic effort to create “euphoria.” Not just well being, but euphoria. Why? So that asset values will rise. Not through savings, investment and hard work, but by magic. This kind of talk has been unique to America in the history of economic bubbles.

“Every major crisis has its origins in excessive overconfidence.”

Greenspan was the worst of them. He has influenced a whole generation of believers. What they see is the short-term benefits of the “asset driven” economy. Indeed, the short-term effects have been wonderful. But the long-term results will prove disastrous.

In Europe, we begin with a low opinion of public officials. We expect them to be competent, but we harbor no suspicion that something good will come from them. In the United States, you write and read best-selling books lauding them as heroes. “Maestro!” What is this? He was the worst of them all. Not only did he encourage and abet overconfidence in the markets – and in the American economic miracle – he has done his best to prolong it as long as possible. Now, Ben Bernanke has inherited the strategy.

Even in the United States, economists used to be concerned with the economy as a whole, the wealth of the nation, to paraphrase Adam Smith. But no longer…now the economists are in bondage to Wall Street. There is no serious discussion of “economics” or “macroeconomics” – only the effect of key statistics on the Fed’s interest rate policy. And what that policy is likely to do to “the market.”

*** At some point, Alan Greenspan was persuaded he could mitigate any damage caused by a collapsing bubble, because of the effectiveness of monetary policy. The monetarists, starting with Milton Friedman, never look at credit expansion – or where the money comes from. They look at price indexes only. They only want to know the effects of monetary policy on the financial markets, which today include housing.

The classical economists, on the other hand, recognize that the excessive credit expansion has many impacts on the financial markets and the real economy.

  • Asset prices, including houses, inflate.
  • Savings rate disappears
  • Trade Balance goes negative
  • Capital Investment dries up
  • Wages and employment drop

Ben Bernanke has already “improved” on the strategy. As he stated, he believes it’s America’s duty to consume the world’s savings because of the U.S. role as the “economic engine” of the world. “Who will take over if the U.S. falters?” they ask.

“That’s a stupid question,” asserts Dr. Richebächer.

National economies should not spend more than they produce…the savings rate and the rate of credit expansion should be roughly equal. There has always been globalization, but with a different concept. Every country must grow at a healthy rate, on its own. It is only through excessive confidence that Americans can justify their high levels of consumption…and then turn around and claim it as their “duty.”

The Daily Reckoning