Thursday, June 26, 2014

Yep - those are economic red lights, sure enough

Last week I published two articles dealing with our economic decline, which appears to be growing more precipitous by the day.

Yesterday came the news that the revised figures for US Gross Domestic Product during the first quarter of 2014 fell by a massive 2.9% (after being initially announced as much better than that).  Make no mistake - this is an economic disaster.  The pundits are already trying to claim that it's the result of bad winter weather, and that things will be better next quarter - but any improvement will probably be the result of deliberate data massaging.

I can't predict when the next crash will come.  There are all sorts of factors - not least among them being increasingly desperate politicians - that can and will influence events in the short term.  However, in the absence of massive inflation to eat away the present value of our indebtedness so that it can be paid off with increasingly worthless dollars, it's now a mathematical certainty that we're facing a crash sooner rather than later.  The cycle of debt and credit has gone about as far as it can go.  It's downhill all the way from here.

In particular, note Charles Hugh Smith's take on 'The Coming Global Generational Adjustment'.  Bold, underlined text is my emphasis.

The Grand Narrative of the U.S. economy is a global petro-dollar empire that has substituted financialization for authentic, sustainable economic expansion.

. . .

Large cohorts generate their own self-referential feedback loops. A large cohort of home buyers drives up real estate as demand exceeds supply, and those who get in early are handsomely rewarded. Those seeking similar returns provide the fuel for further advances. This is the basic story of housing from 1974 to 2006 and the stock market from 1981-2014, as the Baby Boom cohort bought houses and saved for retirement via stock and bond mutual funds.

As the Boomer cohort sells its homes, bonds and stocks, supply will exceed demand and prices will decline, especially if household capital and access to credit are also declining. This selling cycle will also be self-reinforcing.

Central banks have masked this generational selling by becoming buyers of last resort. The Fed has purchased trillions of dollars of Treasury bonds and home mortgages, to push interest rates to zero and prop up a generationally unsustainable housing bubble. But central bank buying of assets to prop up valuations also generates unanticipated blowback: To quote songwriter Jackson Browne: Don't think it won't happen just because it hasn't happened yet.

Mainstream financial pundits were crowing that household assets recently topped $80 trillion in the U.S. Inflate bubbles in real estate, bonds and stocks, and it's not surprising that nominal net worth goes through the roof.

As a back-of-the-envelope calculation, I reckon $40 trillion or half of this sum is phantom, meaning that it will vanish into thin air when these enormous asset bubbles deflate.

These bubbles are all based on one-off conditions that cannot be repeated: the global boom fueled by a now-maturing China, the central banks pushing interest rates to zero and "solving" a credit crisis of phantom collateral by issuing an unprecedented flood of new credit and buying trillions of dollars of assets at bubble valuations, and a surge of new fossil fuels from Africa and North America.

The reality is that promises made two generations ago were made in circumstances that were not as sustainable as those making the promises believed. Extending linear projections in a non-linear world inevitably generates wrong conclusions. Promises made in one set of rosy circumstances are no longer valid in an entirely different and much less rosy set of circumstances. The citizenry will have to adjust to these systemic realities, and demanding we wuz promised is guaranteed to lead directly to failure.

All sorts of promises, explicit and implicit, were issued to win votes. All the promises are now empty, and we might as deal with this reality head-on--if we can muster up the almost-lost ability to deal with reality rather than rely on fantasy/wishful thinking.

There's more at the link.  Highly recommended reading.

If you are depending on the value 'locked into' your home, or investments, or other assets to fund your retirement (or future lifestyle), you're in trouble.  I've said before that if I had property, I'd sell it now for the best price I could get, not holding out for top dollar, because I expect the housing market to collapse again in the near future - probably worse than it did in 2007-08.  I've seen nothing to make me change that prognostication.  Furthermore, if you expect Social Security to fund your retirement and Medicare to look after your health costs, you're living in cloud cuckoo land.  There simply isn't enough money available for that to happen.  Everything you contributed over the past few decades to those programs has been wasted on other things by a spendthrift government.  You've got very little hope of getting much of it back.  See Charles Hugh Smith's take on this subject if you're not convinced - it's worth reading.

Folks, I think this is the calm before the storm.  Make sure you've got a hole to crawl into when it hits.



Anonymous said...

You keep recommending the sale of owned property, but that leaves you at the mercy of having to rent. Rental rates (at least in my market) have been climbing steadily at 10-15% / year. It seems to me that if you have property (and even better, if you own it outright) that keeping it is a better idea, unless you're relying on the money locked into it to fund something. Me personally, I view my mortgage as a locked rate rent payment and if I get nothing back out, well that's the same as if I rented for the same time.

SiGraybeard said...

You will note (and said) they're claiming that the harsh winter caused the economic contraction, but there's evidence the harsh winter actually increased spending and activity.

Our good buddies over at Zerohedge, It Turns Out That The "Harsh Weather" Is Actually Boosting The Economy

Anonymous said...

Peter, I love your blog and have all of your books on my Kindle, but I think your assumptions about real estate are misguided in a couple of minor areas, and I think it might be causing you to give bad advice. I believe Anonymous above has the right idea. If there is some sort of collapse, then property you own will still be there and still have value after the collapse.

In a major upheaval, the two possibilities basically are for inflation or deflation. Every single banking and financial and governmental institution and agency is spring loaded to do everything in their power to kill off deflation. Inflation, to many of them, is an acceptable if not desirable outcome. The likelihood of massive deflation is miniscule. The likelihood of substantial Inflation is almost certain, and INFLATION FAVORS THOSE WHO OWN HARD ASSETS LIKE REAL ESTATE!

Consider my wife’s mother, who purchased her home in 1963 for about $17,000. She paid off the mortgage in the requisite 30 years at about $100 per month. If she’d been renting when the Go-Go Disco inflation rates in the 80’s hit, her rent would have gone up about 150% from 1979 to 1985, but instead she kept making the same $100/month payment. Her income (and later her Social Security) went up, and so did her small pension and the small but tidy investments she was able to make in the stock market, but not her house payment. By the end of the mortgage, she was basically paying the monthly payments out of pocket money. It was the only way she could afford to remain independent and live in a house after her retirement, and she lived there, financially secure, until she passed almost in her 90’s.

If you think inflation favors those who own hard assets, it MASSIVELY favors those who own hard, income-producing assets, especially when purchased on reasonable interest loans.

Consider my mother, who started buying houses as her retirement plan in 1971. Her first house cost $22,000, had a mortgage of about $135/month. It rented for just a shade under $125/month. In 3 years the rent had increased (due to inflation) to cover the mortgage. She invested a total of about $2000 in that house between down payment, repairs and mortgage support. We ate a lot of tuna casserole with no tuna in it, and she taught her young children how to paint and do yard work, but 1974 was the last year she ever put more money into the house than she took out of it.

In the 80’s, inflation basically paid off the mortgage over a decade early with cheap dollars, and her rents kept going up to match inflation. She still owns that house, and it now rents for $875/month. It hasn’t had a mortgage since about 1990. It has netted her over $245,000 in cash income since she bought it, and it’s now worth about $100,000, for a net lifetime gain of over $345,000 on a $2000 investment. Find another place to come close to that performance, anywhere!

When should she have sold it? Should she consulted her Ouiji board to time the market perfectly in 2006 and sold it for $150,000, (before commissions and closing costs) then bought it back in 2010 for $75,000 (plus commissions and closing costs, plus renovations to make it ready to rent)? She’d have made about $50,000 in speculation by doing that. She’d have LOST about $40,000 in rental income during that time, for a possible maximum gain of about $10,000 IF SHE TIMED IT PERFECTLY! And let’s not even talk about the tax consequences.

If she’d had perfect knowledge that the market was going to tank to the tune of 50% and EXACTLY WHEN it would, she might have come out $10,000 to the better, by risking her entire asset on speculation about a bear market. Still think that’s a smart play?

FormerFlyer (more below)

Anonymous said...

If you are going to invest in real estate, then you could do worse than follow what I outline below:

Start with the understanding that cash flow negative investing is risky. My mother pulled it off (once), but she knew she was taking a risk, and she didn’t do anything but sweat out that house until it was paying her, not the other way around. So put as much money down as needed to be cash flow positive, and pay off the mortgage as soon as possible.

Real estate investing takes lots of years to work out properly. This is the “get rich slowly” program. If you want huge returns very fast, can I recommend a ticket to Las Vegas? You will have to hold this property for a couple decades if you want to have these numbers be reliable, but you’re investing for your retirement, not to finance next year’s trip to Orlando, so you need to think in terms of decades.

If a house costs $200,000 and rents for $1,100 a month, it will lose money for quite a while if you put a normal down payment and mortgage on it. You can count on a rental being vacant about 1 month a year, and you can count on about 1/3 of the remaining income going to non-mortgage carrying-costs (taxes, insurance, repairs, management fees, etc.). Therefore that house will have a net income of about $8,000 a year, or an average of about $665 a month. So that house can support about a $90,000 mortgage at today’s investor rates (5. 5% or so). To buy that house as a cash flow neutral investment you need to put about $125,000 into it (down payment, closing costs, refurbish the place a bit, etc.). So either have a whole lot of cash to put down up front or keep shopping for a better investment.

So you shop around a bit and find a house in a decent working class neighborhood but in a different area of town. You found a place where lots of people are coming for work, (factories or maybe an industrial park nearby) or maybe near a college, but the houses aren’t fancy or new. You buy a house that can comfortably provide a home for a normal family, a 3bd/2ba that’s a little older, and you acquire it for $115,000. It still rents for about $1,100 a month (because rents don’t vary as much as purchase prices do), so you only need about $35,000 in cash. Now you’re cooking! Rents will increase at about the same rate as inflation, over time, so that cash flow starts to get better in couple of years.

That house will pay off its mortgage to the tune of about 2-3% per year at first, so you are reducing your mortgage obligation by about $2000+ per year outside of the cash flow. Over time, it will appreciate in value about 3-4% a year (almost perfectly matching inflation, imagine that!), so you will have additional equity appreciation of about $2500 a year. Combine the two for total equity increase of about $4500 to $5000 per year.

Let’s look a decade down the road. 3% inflation per year, so rents are now about $1435/month, netting you about $200/month. You will have banked about $12,000 in positive cash flow in that period. The mortgage will be down to about 74,000, and the house will be worth about $150,000. So cash flow and equity combined have netted you about $85,000-$90,000 in 10 years, on a $35,000 investment. That’s about 10-11% annual Return On Investment. Good luck finding THAT return today.

FormerFlyer (who apologizes for writing a book instead of a comment)

Anonymous said...

Last part of this, I promise;


So how long should you wait before trying to buy this house? How will you know when the market has bottomed out? Who will be holding up the flashing “BUY NOW” sign? From the long term perspective, that sign is flashing NOW! Houses can be found in many markets that can be acquired for about 110-130 times their monthly rent, which is close to the sweet spot for investing. Mortgage interest rates are at historically low levels.

Unless you believe there will be massive deflation, then buy whatever real estate you need or are in position to invest in when you can buy it. Don’t take on huge debt. Don’t take on cash flow negative properties. Buy and hold, and retire on the proceeds. If you believe deflation is in our future, then do the same schedule as above, but save until you can buy for more cash and have a very MINIMAL MORTGAGE. Then deflation just means that your investment is underperforming for a few years, not going broke and taking you down with it.

Oh, and my mother’s portfolio mentioned above? She just passed her 70th birthday, and she now owns over 30 houses. Her income is over $250k/year, and her net worth is well into 7 figures. And, while she holds on to her real estate license out of stubbornness, she hasn’t cashed a commission check in almost two decades. Doesn’t need to.

(sorry again. Just couldn't stop until I'd gotten it all out of my system. Feel free to 86 me for abuse of comments.)

Peter said...

@FormerFlyer: You're accurate in your comments, but they're from the point of view of a property investor. From the point of view of a person who wants to live in a property, things look rather different. Right now, whatever you buy might lose a third to half of its value within the next few years; so I can't recommend it. On the other hand, if you want to sell property now, I'd do so as fast as possible and hold onto the cash for dear life. You can use some of it to settle other debts, and buy another house at a (possibly much) better price in the not too distant future.

See Charles Hugh Smith's articles. He confidently expects up to half the 'bubble' values of commodities like stocks and housing to disappear in the coming correction. I see no reason to disagree with him. Investors owning property for its rental income probably aren't too worried at the prospect. Those who have one property in which they live, and in which a significant proportion of their net worth is tied up, are in a very different position.

Will said...


the current ACTUAL inflation rate is close to 10%. The official .gov figures are bull droppings.

I would not buy commercial property for an investment. Lots of empty retail stores, and other types, out there. Have a friend who got into this area just before the last bust in '08(?), and the bank that was renting one of his properties doesn't exist anymore. Think there is a need for more bank branches now? I think it's still empty. When the economy contracts, retail gets hit first, and it spreads from there. Very easy to lose your shirt in commercial real estate, even in good times.