The second biggest bubble in the world: Canadian housing

A mea culpa is in order. After a good 2008, my predictions on Canadian housing for 2009 are going to be a disaster. I admit it.

However, nothing I have seen to date tells me that the longer term direction of housing in Canada is going anywhere but down.

Due to government manipulation (see this excellent blog posting) which has surprisingly worked and record low interest rates, the Canadian housing bubble has reflated. Reflating bubbles are extremely rare, especially when combined with a stock market crash and a recession. Nonetheless, here we are.

Longer term, the housing market is going to go much, much lower. I believe that this echo bubble is completely nonsensical. Why? We are in a world of deflation, folks. Asset prices, incomes and wages are all either stagnating or dropping. Not just for months but years. Due to this echo bubble, the Canadian housing market has avoided the vicious circle of falling prices that create foreclosures (for now) which create lower prices (California).

However, the amount of debt in Canada is way too high. Despite what has happened to the rest of the world's housing, Canadians still believe that a 4% mortgage with 5% down for 35 years is completely sane. Based on the past decade, they have been correct. When this bubble truly deflates, a very similar experience will happen.

Forget all the explanations of subprime etc.... Those are revisionist explanations and symptoms of the problem. I look at time and price. When time is up on this boom, price will deflate. Canadian prices rose as much or more than US prices, and now for much longer.

Read this G&M article and tell me if it makes sense:

Why, after all the building of the past decade and the unlimited space that we have in this country, is there a perception of a shortage of housing?

The Canadian housing bubble is becoming as bad as the American one. A generational or lifetime high price in housing is happening as we speak and the bears have been capitulated. I plan on writing more on this as time permits.

US carry trade

Art Cashin stated months ago that the US dollar carry trade was ruling the roost. I think he was 100% right. The key thing to watch will be the US dollar. As long as it is sinking at an orderly rate, everything else (commodities, credit, stocks, all other currencies) is going up. The world is long assets and short USD.

When it reverses (and I believe it will; a number of technical measures are moving toward a reversal, but not quite yet), this will crush these asset classes. I am watching the USD carefully. A move above RSI 55 may be the key (it is currently 31) and above its previous resistance around 78. First we may need a mini-crisis (perhaps a quick drop to the low 70s) in the near term to trigger the reversal.

Disclosure: Positions in USD, Euro, Cdn cash, positions in select SPY puts, JPM puts, IBM, CM.TO, BMO.TO, TCK-B.TO

The Towel

In a post a couple of weeks ago I posted:

4) USD bottomed in early August?
5) Credit market topped in early August?

6) Gold/Silver doing a double bottom in late August?

Oil and commodities did a double top in early/mid August?

Stock market topped late August?

We need confirmation from the USD (rally to 80+), gold/silver to take out 70/72 and credit markets to tank.

This would likely confirm a top in commodities and stocks and allow for a substantial correction at a minimum and even possible a break/test of the March lows. To this list, I would also watch:

A) Financials

B) Yen

C) TLT (proxy for long term treasuries)

We know know that

4) USD headed lower and still sinking

5) Credit markets are doing just fine (for now)

6) Gold/silver ratio is heading to new lows

Financials are behaving fine (for now), TLT is doing OK and the Yen is soaring (normally a warning, but may be simply a reflection of every currency up vs the dollar).

All, in all, I have to respect what I wrote that day:

If we rally back over S&P 1040 right now after today's move to 998, then the bearish case may have to wait until 2010.

We got no confirmations from any of that list.

S&P hit 1068 today. I closed out almost all of my shorts around 1030ish, and I am in wait and see mode. I don't think the bearish case will wait until 2010, but anything is possible here as the bulls are in the driver seat. It remains to be seen if the car is heading off a cliff, though. Almost all major asset classes are at critical levels (gold, USD, Euro, stocks, etc...) and I believe the reversal will be incredible. However, for the short term, I need some sign of a reversal. Thus far in 2009, I have either been wrong or very early. I still believe that I am just early, but once again, I will wait for confirmation. A blow off move has ensued and a move to 1100-1120 is very possible. I still believe that new lows are coming and that this depression is a multi-year process. For now though, discipline must trump conviction.

The position that has caused me the greatest problem this year has been holding too much US cash.

Disclosure: Positions in USD, Euro, Cdn cash, positions in select SPY puts, JPM puts, IBM, CM.TO, BMO.TO, TCK-B.TO

Winter Update

On July 6, I stated that I thought winter had started and that a top had been formed in mid June. On July 13, I recognized that a short term bottom was in, and a week later, when it became clear that a bull stampede was in place, that the real move down (ie winter) might have to wait until August.

It's OK to be wrong, in my opinion. Just try be wrong small. Easier in practice than reality, but that is another story.

In my July 6 piece, I identified why a top was in. Clearly it wasn't at that time. I thought it would be a good idea to update (in red) those items:

1) Lowry's Report. Basically, they are saying that the underlying demand and supply of the market is much worse than what the price action of the indexes is indicating. Their head Paul Desmond recently went on CNBC to say this and he expects a break of the March lows. A big change, as Lowry's has become a cautious bull. Therefore, this point is no longer valid for the time being.

2) The gold/silver ratio is warning of trouble ahead (thanks Bob Hoye) by jumping to 70 from 61. A similar jump happened last August. We all know what happened in September 2008! This ratio often leads in a crisis. Signal reversed after hitting 72. It has since dropped to 63, a level which it hit in August and now. Bears watching carefully. I want a move to 72+ to confirm ideally.

3) The US dollar appears to have bottomed. Another nail in the coffin of the bulls if it is true. Another false bottom but recently the US dollar has shown signs of turning up. Again, not clear yet. I want a move to 80 in the USD index with a daily RSI of 55+.

4) Commodities appear to have peaked. Another nail. Commodities rallied but look to be weak again. A true bottom in the USD is necessary for this to be confirmed.

5) Jeffrey Cooper from Minyanville.com, one of the best out there and a master of cycles analysis, has been warning of impending trouble from mid August onward. I agree. Still warning, and looking for a real sharp move down in September/October.

6) The green shoots were a myth. The proof is overwhelming that all you had was a slower decline in GDP not a return to sustainable growth (ie underlying demand, not inventory building). You could conceivably have green shoots at some point. I just don't see them yet. The biggest green shoot is the stock market. Yeah, that worked out real nicely in October 2007, when the S&P hit a new high, a month before the recession started, didn't it? Also, last month's US unemployment figures were horrible (while better than earlier in 2009, they were worse than anything in the last recession, including the period after 9/11- remember all those airline layoffs!). Consumer spending has also been atrocious of late. No real change in my view. Inventory building is taking place but final consumer demand looks to be getting worse not better. Case in point, retail sales in July stunk up the joint. Even with the cash for clunkers socialist gimmick, US retail sales were down 0.4%. Wal-mart comps were down 1% and then stated that they are taking market share (I believe it; when times are tough, people are going to Walmart). The stimulus effect is wearing off and there has been little or no positive impact on retail sales. Any recovery with the US consumer (70%) is suspect. If every other sector of the economy picked up (business investment, exports, housing, government), a recovery without the consumer would be possible. So far, That would be complete hope though as there is no sign beyond inventory rebuilding and government intervention that any of this is gaining any traction.

7) The history of monster bear markets is that they often have 40%+ rallies and then ultimately go to new lows. Look at the Nasdaq 2000-03. Ditto for Dow 1929-32 and Japan 1989-? Their purpose is to reset the shorts (by stopping them out or burying them) and suck in the bulls. Bear markets are as much a function of time as price. We have had a severe decline in price (although I think we need more). In terms of time, for a megabear market, this one has been quite short (20 months). More time is necessary to change psychology on a long term basis. No change, except that the rally went to 50%+, similar to the 1930 Dow rally. That rally failed and went down another 83%.

8) Sentiment has become almost universally bullish. It always does in a bear market rally after a crash. There are no shortage of people who have claimed that the worst is over. I believe the worst is coming. Even some of the bears are only looking for a retest of the March lows (the bulls are looking to 1000 to 1300 and laugh at the thought of a retest; they are convinced that a 40% rally means that a new bull market has started). I am looking for a break of the March lows. Sentiment hit 2007 levels last week. Bears are under 20% and bulls are over 50%. Very bearish.

9) International problems are likely to rear their ugly head (North Korea, Iran, swine flu, Latvia, Ireland, Chinese smoke & mirrors- I am a China skeptic). China is the biggest factor. Everyone is bullish on the emerging markets. China is down 24% in the past month. This needs to be watched, but without China, the emerging markets are suspect. Russia is already well off its rally highs. India and Brazil appear OK for now. This bears watching closely, and is related to items 3 & 4. Without China, commodities have headwinds. Without commodities, the S&P has problems.

10) The recent spike in long term interest rates is a possible warning shot of problems ahead. Higher interest rates are sinking the economy and are likely to cause further problems as they spread to non-government bonds. Nothing alarming yet. However, non-government bonds (corporates & junk) are below their recent highs, and again bear watching. Emerging market bonds have also sold off recently (see point 9). Government bonds are rallying.

I would like to add that I am watching the Baltic Dry shipping index, which gave a 1 month warning on the top in commodities last summer, which in turn gave a 1 month warning to the trouble in the main stock markets. This year, the Baltic Dry double topped in early June. This has not yet cracked the commodity markets but has formed a possible double top (June and August) and not allowed commodities to hit a new high despite the new highs in the stock market. In addition, the Baltic Dry has preceded the Chinese stock market top by 2 months. Unlike Chinese statistics, the Baltic Dry is driven by market forces.

I am also watching credit spreads (JNK and CYE are good proxies). These had huge runs since the spring lows and may be rolling over.

I have prepared a separate post on warning signs.

Conclusion: Where does that leave us?

In no-mans land for now (S&P 998). The time for the bear case is pretty much now or never (for 2009)

If we break above 1040, a move to 1120 is the most likely scenario. At that point, I would be forced to drop the bear case for at least a little while and maybe play the long side. If we break below 978, I think a move to 940/950 will be quick. If we take out 940, a confirmed fall sell-off is very likely.

Do we break the March lows? I am painfully aware that a move to S&P 666 is approximately -35%. Is it possible this fall? Yes, if we get some real ugly events (bank failures or country failures) like we did last year. Forecasting such events is perilous at best. I firmly believe that we are going to test and ultimately break those lows. Will it happen in 2009? I honestly don't know.

One scenario that I am grappling with is that we sell off to a higher low such S&P 800ish and then rally to a new high in early 2010 (1120?). This would gets people crazy bullish with a higher low and higher high. This would be a false hope and we could then crash later in 2010.

Another scenario is that we could hit 800 and then rally to a lower high, and then fall later in 2010.

The final scenario (and one that I still believe in, albeit less than earlier in the year) is that we crash this fall and take out S&P 666.

I strongly believe that a sharp move lower is coming over the next few weeks that should take us to the low 800s on the S&P for now.

When the move down is confirmed by the price action, I will revisit this whole "break the March lows" issue. To get to the March lows, you need the financial sector to be in shambles as was exposed in late 2008/early 2009. If the financial sector is able to avoid another debacle, then a higher low is likely.

If we rally back over S&P 1040 right now after today's move to 998, then the bearish case may have to wait until 2010.

Disclosure: Positions in SKF, QID, HOD.TO, FXP, SPY, EUO, POT, TCK-B.TO, HDU.TO, Cdn & US financials options and stock, US&Can cash

Checklist for market warnings

I have prepared a checklist for intermarket warnings as most markets peak before the stock market, and all markets are interconnected. I have left out US treasuries for now as they haven't warned (yet?). They may in the future.

There were 6 major warning signals given last year that warned of the debacle in the fall of 2008. This year, 3 of them are giving warnings, and another 3 are still up for debate (in red). For a major top to be confirmed (S&P 1018 as of August 7th; currently 996 as of August 19th), the USD has to rally big-time and commodities and credit markets have to sell-off.

The remaining weeks of August into early September should be telling.

Summary of 2008:

May:
1) Credit markets peaked in early May. Major warning. Major problems continued into the summer.
S&P peaked at 1440 in mid May (2 week lead)

June:
2) Baltic Dry peaked early June. (Chinese stocks already topped in early January and resumed downturn before Baltic Dry in mid-May)

July
3) Commodities (incl oil) peaked early July (1 month after Baltic Dry).
4) USD bottomed in mid July (2 weeks after commodities topped)

August
5) Chinese stocks rolled over in early August.

6) Gold/Silver ratio soared in early August.

September
S&P topped Aug 11 and double top Aug 25 but was basically in a trading range until early September. It rolled over and did a waterfall decline into early October.


In 2009

June:
1) Baltic Dry peaked again in early June.
Gold/silver bottomed in early June.
2) Oil and commodities did a first top in mid June

July

Stocks bottomed in early/mid July and then embarked on a blow-off top into late August

August
3) Chinese stocks rolled over again in early August and head sharply lower.

(Baltic Dry down sharply)

4) USD bottomed in early August?
5) Credit market topped in early August?

6) Gold/Silver doing a double bottom in late August?

Oil and commodities did a double top in early/mid August?

Stock market topped late August?

We need confirmation from the USD (rally to 80+), gold/silver to take out 70/72 and credit markets to tank.

This would likely confirm a top in commodities and stocks and allow for a substantial correction at a minimum and even possible a break/test of the March lows. To this list, I would also watch:

A) Financials

B) Yen

C) TLT (proxy for long term treasuries)

Disclosure: Positions in SKF, QID, HOD.TO, FXP, SPY, EUO, POT, TCK-B.TO, HDU.TO, Cdn & US financials options and stock, US&Can cash

Moving

I have moved within Montreal so I have been swamped and I haven't had the time to post.

Did I buy something? Nope.

I still believe that housing in Canada is in a huge bubble, and also for non financial reasons, I am still renting.

I really enjoy posting on this blog and I welcome all feedback, both positive and negative.

Thanks!

The biggest bubble: China

Twenty years ago, when I was in high school, Japan Inc. was all the rage. Even in my university years (early 90s), Japan's version of capitalism was considered by academics and the mainstream media to be superior to the US.

Japan had keiretsu capitalism, whereby a group of companies were interlinked. The Japanese were hard working. They had to be forced to take vacations. They were smarter than Americans (or Canadians). They were buying up prized American assets. They had lifetime employment.

In reality, they had a huge stock market and real estate bubble. They had poor demographics (they did not enjoy the baby boom post WWII for obvious reasons). Their smart workers were not as creative as the "fat and lazy" Americans (look it up: that is what one official called Americans back in the early 90s; also a fantastic SNL skit with Mike Meyers). They are good at high end manufacturing (witness Toyota, Honda and Sony) but I'll be surprised if anyone can name any high-tech startup from Japan with any international significance. Keiretsu capitalism is now known as crony capitalism. Their banking system was insolvent. We now know that their system was not very adept at dealing with poor economic times, and their reaction to their depression was quite poor and not very dynamic.

All this is not to Japan bash. In fact, their story is remarkable. The Japanese are a smart and hard working people. They rebuilt their economy after the devastation of WWII (imagine the loss of millions of citizens and 2 cities being annihilated by nuclear weapons!) in one or two generations. I believe that things got ahead of themselves in Japan in the 80s and their system was not built to succeed for the 21st century (with creative and dynamic companies). I also believe that when this global recession/depression ends, Japan will fully participate in a recovery.

Again, when I was a young kid, the USSR was feared. Their hockey teams and Olympic teams were dominant. In Hollywood, their characters were always tough villains (think Rocky 4) or they were ready to launch nukes on us. On TV, their pre Gorbachev communist leaders were old and scary. Their military was very powerful and we were always worried about doomsday clocks and nuclear war.

In reality, the Soviet Union was a paper tiger. Yes, they had nukes but their economy was in shambles and much of their military was dysfunctional. We confirmed that totalitarian communist governments don't work. Their union was a joke and many of the countries that they kept in the Union by force either became separate countries or are still trying to get there. The Russian people were not to be feared and they wanted many of the freedoms that we have.

Why the history lesson from the eyes of someone born in the seventies? Because I am now old enough that I feel as if I have seen this story before. I am talking about China.

China has some strengths but unfortunately, it shares some of the worst qualities of Japan and the USSR.

China is a one party totalitarian government. To their credit, they have moved away from communism, but nonetheless, the central government has a ton of control over the economy. The recent stimulus is a case in point. The central government is also very involved in banking and fixed investment, which is supporting the economy at present, despite a huge drop in exports. We currently fear the Chinese military, although not to the extent of the USSR circa 1985. We all remember the disgusting Tienanmen Square massacre of 1989.

China is similar to the USSR in that it too is not truly a union. Tibet and Taiwan are two of the high profile cases. However, much of China is not homogenous. You have Christians, Muslims, Buddhists and different ethnic groups. You also have hundreds of millions of rural and mostly uneducated citizens as well as hundreds of millions of educated and urban Chinese that live centuries apart. All these interests are united by a totalitarian government. It is unlikely that China will stay together in the future. At some point in the future, China may well have the same problem that the USSR did and fragment.

China is also similar to Japan 1989, in that the West is so bullish on China, that they are suspending all rational thought.

Take a look at this gem of a quote from a survey discussed in Bloomberg:

Two-thirds of respondents say they are optimistic about India’s prospects, as are 70 percent on China. “The Chinese economy is run by the government, managed by the government, helped by the government,” says Omri Beer, an options trader at Nomura Holdings Inc in Tokyo. “It’s easy to be bullish.”

Or the Yuan as a global currency. It is not even the dominant Asian currency. It is not even freely traded. Even the respected Nouriel Roubini has been talking up the Yuan as a replacement to the US dollar. I vehemently disagree. One day, the Yuan may be considered in the same light as the Japanese Yen, but not as the senior world currency. Not any time before 2050 and probably not at all. It took the US dollar decades AFTER it surpassed the UK economy, and two world wars, BEFORE it became the dominant world currency. Even if China becomes the dominant world economy one day, it may take decades after that for the Yuan to become the dominant world currency.

Most in the West believe that the Chinese government is so wise and all-knowing. Their stimulus plan is genius. Their management of the economy is superior to a market based economy. They are combining the best of communism and capitalism. Their stockpiling of copper is genius, despite prices being historically high. Their GDP is growing while ours is shrinking.

The reality is very different. Have you seen their leaders? I wouldn't trust them to run a multinational company let alone one of the biggest economies in the world. Sadly, I could say the same about President Obama, but I digress.

I wouldn't trust any number coming from their government. Studies have shown that their GDP numbers are way too smooth given the relatively early stage of development that their economy is in. So when they report GDP, take it with a grain of salt. I will acknowledge that their stimulus appears to be "working". Yes, because they are forcing banks to lend, fixed investment to continue regardless of return on investment and people to consume. This can work for a short period of time, until the banking system is shown to be insolvent (Japan), the fixed investment ponzi scheme is exposed and the demand from consumers is saturated.

Their exports are mostly based on being the lowest cost and the quality is often suspect. Part of the low cost is the huge labor surplus and part of it is the manipulation of the Yuan. I suspect that China will attempt to move upmarket in the future, but I don't believe that the Chinese share the Japanese' love of quality. Also, there is again the same problem that the Japanese have with creativity and innovation. Name a truly international multinational coming out of China that is changing the way we live, like RIMM or Apple?

I have no idea when the China bubble will burst, but when it does, I think it will rival Japan's bust. It may not last 20 years but 10 years is a definite possibility.

I know the math about how China gets to be the dominant world economy. You take 4 times the US population and 25% of the GDP per capital of the US and presto, you get the biggest economy in the world. If only it were so easy. That population could shrink in a fragmentation scenario and their GDP is inflated by their own bubble. Again, I don't think the Chinese people are any different than you or me. They want the same freedoms and opportunities that we have. Many of them have immigrated to Canada, and they are a great asset for us. I just don't think that the Chinese system is superior and I believe that over the next decade, China will be derided for all of its mistakes.

Disclosure: position in FXP.