There is an impressive amount of garbage in today’s headlines to sift through. Most of it, of course, is rubbish. But there are probably two main takeaways from the last 24 hours: don’t fall for the earnings recovery story, and housing is still a sucker’s bet in countries whose names begin and end with the letter “A”.
Let’s take the earnings recovery story first. Tomorrow we’re going to have a look at the outlook for Aussie bank earnings. But for now, is there a case to be made for stocks as an asset class? Are they really recovering?
Well, the S&P 500 closed down in New York. But it’s up 57% from its low. That’s impressive. It’s also expensive. The index now sells for 20 times operating profits, which is pretty optimistic, given how crappy the world economy has been in the last year.
“But that was last year,” you say. In the future, things can’t help but be better! And relatively speaking, that’s probably true. Our friend Dan Ferris writes, that, “Last year, the S&P 500 lost $23.25 per share for the fourth quarter. In the second quarter of 2009, 369 out of 478 companies, representing perhaps 97% or 98% of the total market cap, reported negative earnings over the previous year.”
Compared to last year, this year HAS to be better. You can’t get much worse than negative earnings. And with trillions in credit backstopping the financial system and making it possible to generate profits on paper assets, you’d expect to see at least some engineered earnings in the next two quarters that look absolutely dazzling when compared to last year’s numbers.
“So,” says Dan, “for the next two or three quarters, you can expect plenty of reports of vastly improved earnings, even if those results aren’t really so great. As you parse the news and evaluate your own investment goals, keep your head about you and don’t be afraid to spend extra time getting deeper into a company’s numbers, its market, its history, and its future prospects than you normally would. And for Newfoundland’s sake, don’t buy anything that isn’t dirt-cheap.”
Absolutely speaking, the popping of the credit bubble fatally undermined the business models of a lot of heavily leveraged companies, including many, many banks (both big and small). We reckon that the capital cushions of those banks are still in danger from further falls in asset values. Yes, that’s not a popular or even common view. But we’ll expand on it tomorrow.
In the meantime, you can always tell when stocks are out of favour in Australia. Everyone starts talking about what a good investment property is. But Australian housing is not exactly a cheap asset. The Governor of the Reserve Bank, Glenn Stevens, said as much earlier this week.
And this morning, we peeled our eyes over this paper on Aussie houses by RBA man Tony Richards. Richard’s inadvertently made a lot of interesting points. One was that the so-called improvement in affordability over the last year is, “mainly due to movements in interest rates rather than in house.”
He added that, “Mortgage rates are particularly low at present and, as the Bank has noted on a number of occasions, it is not reasonable to expect that interest rates will stay at the current low levels indefinitely. When they do rise towards more normal levels, discussions on housing affordability will again focus more on the level of housing prices relative to incomes.”
That is clever to suggest that when rates rise people will have to find another way to say that houses are affordable. But we reckon when rates rise, as they eventually must, a lot of new home buyers will find out that access to cheap credit does not make a house affordable. It just makes the amount of debt you owe to the bank a lot larger.
The most interesting part of the paper, for our twenty minutes, was the discussion of ‘underlying demand’. ‘Underlying demand’ is the phrase that gets trotted out when the banks and real estate brokers tell you there’s a housing shortage, or when the RBA tells you not to worry about a house price crash in Australia. But what does it really mean?
Richards says the four components of ‘underlying demand’ are population growth, household size, new houses to replaced demolished homes, and demand for “second or vacant homes.” Note that none of these are like the Ten Commandments. They aren’t carved in stone. They are changeable.
By the way, who on earth can afford to own a home they neither live in, nor rent? “Honey we’re going to buy a third home. But we’re not going to generate any rental income from it. And we’re certainly not going to live in it. We’re just going to pay the mortgage on it.”
“But why would we do that dear?”
“Because we can. To show how rich we are. We can afford it. And to support underlying housing demand. What else are we going to do with that money, buy stocks?
Returning to reality, Richards says that a preference for smaller household sizes, along with rising incomes and a rising population all factor in to strong “underlying demand.” But if you spend exactly forty two seconds scrutinising this claim, you’ll find that it simply doesn’t hold up. “Underlying demand” as a bullish factor in Australian housing is a fiction propagated by property spruikers and money lenders.
Take rising incomes. Rising incomes are a function of a growing economy. But in a prolonged recession—or just a period of slower growth, or a world in which wages in the Western world are gradually deflated as the global work force grows (especially in manufacturing)—income growth is going to be harder to achieve across the economy.
And rising populations? Well, it’s always possible for the government to reduce legal immigration if it’s concerned about too many people competing for too few jobs. That knocks another plank out of underlying demand.
And then there’s the preference for smaller households. Of course there’s a preference for having your own castle and being your own King, if you can afford it. But the RBA’s own data show that after many years of smaller and smaller household sizes, the trend is now swinging to larger households.
This could be by preference. After all, living alone has its benefits, but it can be awfully lonely. Or it could be by necessity—children living at home longer to save money or taking on flatmates to ease the pain of higher rates.
But whatever is behind the trend in rising household sizes, the main point is that the elements that go into “underlying demand” don’t automatically suggest a level of demand for houses that will always rise. Quite the contrary, in fact.
And of course one of the biggest factors in demand for housing is the availability of credit via low interest rates. We reckon that when you add a couple of hundred basis points to the current cash rate, you’d take quite a bit of momentum away from “underlying demand” for housing.
How about some reader mail?
I am no financial wizard, but enjoy reading your Reckonings for the alternative viewpoint you present. There is one thing, however, that (unless I missed it somewhere) you don’t seem to have explained. Your comments would be greatly appreciated, even if you confirm my opening disclaimer.
Over the past twelve months you have mentioned many times that a lot of sub-prime mortgages are due for renegotiation (i.e. upward revision of interest rate) in 2010 or thereabouts. You content that this will be a great blight on the market forces.
But as I understand it, at least one State Supreme Court in the USA (Kansas, I think, from memory) has ruled that sub-prime mortgages may be unenforceable because the holders of this toxic debt cannot prove a link to the subject property. Am I stupid then to believe that, if this is correct, no person whose house is subject to such a mortgage should do any more than sit tight, hang in there, and refuse to pay another dime? In effect, they’re living in a free house.
What would the result be for the banks and loans organizations that issued the mortgages, and the ones that now hold toxic CDO’s? Is this in reality what the Fed’s bailout has been all about? And what about those who have already returned their keys — could they be allowed back in?
Intriguing scenario. Politically, it’s a mess. Financially, we reckon the big issue is the value of toxic CDOs to banks and financial firms. Regardless of what happens to homeowners, those CDOs are due for a haircut. And when that happens, watch out for more bank failures and a second buffeting of the financial system.
You do have it bad after your long flight. From your latest letter..”What’s weird is both commodity standard-bearers moved down amidst a flurry of negative headlines about the U.S. dollar.”
24th September was gold options expiry day on the crimex (commex). Gold ALWAYS gets hammered at options expiry. And more so this time around as we had the greatest short position in history, it was bound to be hammered.
Freshen up now you are back. Enjoy your writing.
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