Latest US house price data

OK the Case Shiller house price data is out today (for May). Last months data I pointed out an emerging trend.

"5 cities that did not have a big boom, the change in prices was basically 0 over the last 2 months (with a range of -2% to +1%, while in the boom cities the average was -3.8% (range -1% to -7%). Clearly a significant difference, both statistically and practically speaking. So the recent trend is that in the non boom cities prices are almost stable despite the rising unemployment while in the cities which had booms the price falls are slowing but still there. "

Let's see now looking at the last 2 months if this trend is becoming clearer or was merely a statistical blip. 5 cities that did not have a big boom, the change in prices averaged 1% up over the last 2 months (with a range of -1% to +3%) while in the boom cities the average was -1.7% (range 1% to -7%). So for non boom cities prices do appear to have stabilised while for the boom cities prices continue to fall but that rate of price decrease has slowed significantly compared to 3-4 months ago.

So what does this mean? Well it's probably not too bad a time to buy a house in the non boom cities. However most banks exposures to bad loans are in the boom cities and these are still falling though at a slower rate.

There has been some discussion amongst bloggers about problematic Option ARM loans and when they are likely to default. This discussion has centred on recast and rest dates when payments or interest rates change for these loans. See http://www.calculatedriskblog.com/search/label/Option%20ARM for a summary of Option ARM posts on the excellent calculated risk blog.

As I pointed out in my last post default decision are likely in most cases to depend upon changes in personal circumstances. So defaults are likely to be spread over time rather than bunched according to rest or recast dates. This is what appears to be happening now see http://www.calculatedriskblog.com/search/label/Option%20ARM. US banks face a long hard road ahead.

Forclosures - a short or long term problem?

Over at http://oldprof.typepad.com/a_dash_of_insight/2009/06/interpreting-housing-indicators.html Jeffrey A. Miller has a good post on seasonality in data and on house prices in particular.

On the latest Case-Shiller US housing price data the most interesting thing I found (based on the more reliable seasonally adjusted data) was that for the 5 cities that did not have a big boom, the change in prices was basically 0 over the last 2 months (with a range of -2% to +1%) while in the boom cities the average was -3.8% (range -1% to -7%). Clearly a significant difference, both statistically and practically speaking. So the recent trend is that in the non boom cities prices are almost stable despite the rising unemployment while in the cities which had booms the price falls are slowing but still there.


Looking to the future I look at two questions.
1. How are things going to pan out in the next 3-4 years and beyond for house prices in these various cities in the US?
2. How about foreclosures over this 3-4 year period?

OK house prices. Generally the futures markets and economic forecasters suggest some more falls in the boom markets over the next year or two (say 10-15%) then some flattening out. This seems a reasonable guess to me though of course there's a fair margin of error and clearly different cities and different market sectors are going to have different outcomes. e.g. the high priced end of the market in boom cities may have further to fall as price differentials have widened with the collapse at the lower end and there is a lack of "move up" buyers.

Now turning to the second question what is going to happen regarding defaults and the results modification, foreclosures, short sales etc. i.e. problems for banks. Most commentators give the impression that the foreclosure problem is related largely to sub prime and that as we have worked through a lot of this the problem will be largely gone over the next year as the worst of these loans would have already defaulted. On this basis they see bank losses related to the residential housing market as not being a problem beyond the next 12-18 months. I disagree for two reasons.
1. The recent data.
2. My hunches about why people will default and how often this will happen.

The recent data on delinquent loans (i.e loans where payments are more than 60 days late) show a steady and significant increase in each of the last 4 quarters in the proportion of prime loans going delinquent. Prime loans are two thirds total loans and are the "best quality" loans. So the data suggests a growing and broad problem not related to sub prime that is not going to go away when the majority of sub prime loans have defaulted. Sure you might say "but it's the recession dummy - its' people loosing their jobs and not being able to keep up with the mortgage payments". That's part of it but it's far from the whole story as I outline below.

Let's turn now to the reasons why people default and consider whether this is likely to continue over the next 3-4 years (and possibly much longer).

My hunches are that the main triggers for default are:

1. The pure economic motive. Some people default when they see the value of their property is much less then the value of their loan and they don't expect their house value to improve significantly anytime soon. I presume investors and many who bought near the peak of the boom are in this category. Basically many of the people in this category who were going to default have already defaulted so while this will be a continuing issue I don't see it being the main issue in the longer term unless it is teamed with the circumstances outlined below.

2. Defaults because the homeowner can't afford the repayments anymore. Clearly triggers here include: decreased income due to job loss, a reduction in working hours or being forced to take a worse paying job are going to be triggers. Also clearly this is going to be a big issue over the next year at least. However even when unemployment has stabilised there are still vast numbers of jobs lost and created in any year in a "normal" economy. Coming out of past recessions this has not mattered much to banks as for almost all homeowners their loan value was less then their home value. So the homeowner maybe forced to sell the house (but this caused the bank no loss), or take a second mortgage with the equity they had in the house, or borrow from relatives etc. However for the foreseeable future, in all the housing markets that had the big boom bust cycle, these options are either impossible or no longer in many homeowners best interests. It's in their interest to default. This means even in the years following the end of the recession there will still be substantial defaults where banks will loose substantial money on the foreclosure sale when people temporarily can't afford the repayments.

3. The same dynamic exists as point 2 for situations where some other change in life circumstances triggers a home sale (and where the loan value is greater than the house value). Examples of these circumstances include: moving to another area for job or family reasons, life cycle events that trigger a desire or need to move/downsize/upsize (divorce, marriage, death, birth etc). These are the normal factors that trigger most sales. For many of these people the new reality in "post recession" economic times will be that they will be better off financially by defaulting on their loan.

These three points suggest that, in the markets that had the house price boom bust cycle (i.e most metro markets), defaults and foreclosures are going to be commonplace long beyond the end of the recession. This has four significant implications.
In the post boom housing markets it will mean:
1. Foreclosures and short sales which will dampen any medium term rebound in house prices.
2. A negative impact on the profitability of new construction in those markets as house prices will remain subdued.
3. Ongoing losses over to those lenders that made (even prime) loans in these markets even after the recession passes.
4. Residential housing investment is unlikely to rebound as strongly as it usually does at the end a recession. This will tend to make economic recovery sluggish - especially in post boom markets (like the sunbelt) where the economic situation is already worse than average.

It is point 3 that I have yet to see mentioned in commentary.

Stock market - medium term outlook April 20

On March 19 on my last stock trading update I said.

"Basically I am waiting for a blow off top to put more shorts on. I will sell my shorts if there are real signs of a sustainable turnaround or if the market has a low volatility gentle trend upwards (as occurs in bull markets). "

Well I am still waiting! Markets worldwide have rallied a long way very quickly. I have basically continued making a Little money with short term trades but apart from small potatoes this rally has largely passed my by. Closed most short positions apart from one small one on the Spanish market and then opened a small new short on the US market on Friday.

I looked at stock markets in particular the US market from a macro perspective in January and then in February. The US market continues to lead other markets so remains the focus. Let's see how things as panning out from that perspective and what's changed. My new comments are in italics.

A. Economic fundamentals. Before things actually get better in the real economy the chronological steps we have to go through are:
1. Stop increasing the speed of deterioration
2. Continue to get worse but at a slower pace
3. Stabilise
4. Start to improve.

At this stage it appears we've reached point 2 the speed of deterioration has at least stopped increasing even though the speed of deterioration is still high. This is a step in the right direction in the last 2-3 months but still there's still a fair way to go and there are definite risks in ongoing problems given the underlying issues of high indebtedness and fragile financial systems still exist.

B. The scope of government action. The decrease in real GDP has occurred despite large stimulus and bank bailout measures and unprecedented monetary policy action. So there is not too so much more the governments can do without causing themselves significant long term problems (i.e. government deficits become to large for markets to believe they will be serviced and the Fed ends up lacking creditworthiness due to holding assists worth less than amounts lent).

No change here.

OK so that's the real economy but hasn't the stock market already fallen a lot and discounted these problems meaning we might have seen the bottom?

C. When in the economic cycle are equity returns usually strong? Research indicates that returns in stock markets are very high for 6 months starting in the last 6 months of recession or at the end of recession. So given we're very likely more than 6 months away from the end, and possibly years away, this suggests we should be vigilant for a possible stabilisation in the recession (particularly if its' not related to one off government stimulus responses which will have a temporary impact) but we shouldn't be too hopeful about strong equity returns from this point.

Some economists continue to forecast an end of the recession in 6 months time but they have been forecasting this for about a year now. We certainly seem closer to the end than 2 months ago but it's unclear if this is going to be an L or V shaped recovery at this stage and the finding on stock returns only applies to V shaped recoveries. Check out stock market returns in Japan over the last 15 years since their L shaped recession - terrible!

D. Are stocks cheap compared to earnings? Aggregation of earnings forecasts suggests that when looking at individual companies USA equity market earnings forecasts are way too optimistic given the bleak macro economic outlook. i.e. analysts forecasts are suggesting earnings will zoom up over the next year when clearly the economy looks tougher this year than last. Earning disappointments will lead to disillusion with the market and create strong downward pressure on prices.

Earnings forecasts have come down so there is less scope for disappointment but still earnings are on a downwards path and obviously stock prices have bounced so they certainly don't' look cheap compared to earnings. Based on the last quarter earnings for the SP500 of around $14 the PE of the market is around 60! Clearly banks losses will end at some point and that will drive earning up to maybe around 40 in the next year or two but even that is a PE above 20!

E. Are equity prices cheap compared to the asset values of the companies? Compared to valuation during the last few years yes prices are cheap compared to asset value. But historical standards during recessions equity prices are not cheap. Tobin's Q - The measure of equity prices to prices on assets on the books - is currently around 0.7 this typically bottom's at 0.3 during recessions. This suggests there is a long way to fall. i.e. over 50%.F. Are longer term technical indicators basing in preparation for a sustained rebound? Primary long term trends in all major stock markets are clearly down.G. What is driving equity term markets on a daily basis and does this gives us hope? Looking at the past 9 months the pattern in movement in daily stock prices is astoundingly consistent. Equity markets are rebounding based on possible government actions and falling on the reality of earnings and broader economic data. There is no other "story" of substance out there in the market. Given the size of the economic problem, governments cannot have an overwhelming impact. So once the reality of this hits the primarily stimulus in this market of this "Obama bounce" will be gone and traders will be focused on the bleak macro economic data and the bleak earnings data.

Stock prices around 1.9 times asset values so stocks are now more expensive than previously. Danger.

H. Will the new administration in the US make a difference? Sure they can take actions that will have positive impacts but they are still politicians in the same political, social, cultural and economic system and political/equity cycles suggest bad times ahead. Basically "on average" equity markets in the US perform well in the third and forth years of a presidential term and poorly in the first and the second years. My understanding of this is that in the third and forth years most presidents (and congress and the senate) worry about being elected next time so they need to get out there and sell a positive picture of the economy. However during the first two years they face the reality of not being able to fund all their promises and the opportunity to talk down things and blame their predecessor. No doubt Obama will "discover" things are a lot worse than he thought and he will not be able to follow through with campaign promises.

No change.

I. Buffet is buying so if I'm a long term investor isn't now the time to snap up some bargains? Yes Buffet has been buying (but generally getting a special deal rather than buying at market price as you would be). His interviews suggest he's buying based on his view that this is largely similar recession to the ones he has experienced since he started in 1954. There are two points here. One - this recession looks different in terms of the: possible insolvency of the banking system, the debt levels of the USA consumers and government and the massive bubble in house prices that still has a long way to bust . Two - Buffet doesn't try to time the market, he readily admits he usually buys in too early when the market falls and he buys stocks with very specific characteristics rather than the whole market (often at prices unavailable to others).

No change.

So in summary, things now look slightly more hopeful on the macro front but valuations are not cheap compared to usual recession values and there are significant dangers to any economic recovery when it occurs. One of these dangers is the damage that the unwinding of unprecedented Fed actions may cause. A second is the zombie banks, a third the perilous deficit and budget situations of governments worldwide and a forth the weak financial situation that consumers find themselves in the US and other developed countries I remain cautious in the market and continue to look for opportunities to short the market.

Stock trading March 19 2009

In my March 7 update I concluded.

"So large falls in the short term probably depend on the market coming to believe that:
a. Commercial real estate is some sort of repeat of residential real estate (hope Geithners stress test include defaults from builders on owners in this area - 25% of banks loans)
b. Insurance becoming part 2 of the banking crisis (again based on asset purchases with money that they need to pay back in the future - in this case to policy holders).
c. More panic in credit markets.

If not we could have a bounce despite continuing deterioration in economic conditions. "

Well we certainly had the bounce in stock markets! I closed down about half my short positions after the bounce lasted 2 days and other than that not much change. I am currently short the Spanish market and a small short on the French market. The European markets have generally only advanced in response to the US market jumping each day so clearly European markets do not have an upward momentum of their own at this point.

The so called good news that commentators have ascribed the bounce to has been hardly convincing.
1. Bernake saying the recession may end this year if everything goes right. Hardly news he's been saying the recession "may end in 6 months" for the last year.
2. Banks saying they are profitable (as long as they don't have to take count the losses).
3. Housing starts increased from virtually nothing to slightly above virtually nothing.

Basically I am waiting for a blow off top to put more shorts on. I will sell my shorts if there are real signs of a sustainable turnaround or if the market has a low volatilty gentle trend upwards (as occurs in bull markets).

US housing starts - unexpected jump

The blue line is all housing starts.

The figures graphed above show a jump in US housing starts and this jump is due almost entirely in a jump in multi-family housing starts (apartments, condos etc). The stock market liked this and jumped.

Three points stand out for me on this.

1. This seems to have caught people by surprise and resulted in a significant jump in the stock market. Should it be surprising if you understand housing markets?

No! Why - because there's not one housing market so we don't need to wait till all the inventory is run down in say Californian single family homes before we start building condos in Denver. For more details see my blog from January. IT is worth noting the jump in multi family housing starts was mostly in the north east of the country - an area with smaller boom and bust in housing. http://reflexivityfinance.blogspot.com/2009/01/misconception-2-housing-market.html

2. Is this indicative of a broad turnaround in housing starts?

Maybe in some segments but little change in main markets for the foreseeable future. In this vast majority of markets: housing prices are still decreasing, there is still too much inventory for sale (though this is gradually decreasing), foreclosures continue, rental vacancy rates are increasing and rental prices decreasing.

3. If there is s turnaround in housing starts over the next 3 months will it make a big difference to the real economy over the next 3-6 months?

Probably not. Housing starts have fallen to lowest on record. Even worse than the graph suggests if you factor in population growth. They need to increase 100% from this point to get back to a position where they would be considered terrible in any other postwar recession. So even if we get a turnaround it isn't going have a big dollar impact because it will still mean not a lot of dollars going into building. In addition dollars spent are related more to completions then starts and obviously housing completions lag housing starts considerably. Housing completions are still going to be going down for the next 3 months or more and then increase back to the level where we are now for the next few months. This is because housing starts have been going down rapidly for the last 3 months.

So in summary any rebound isn't going to start to translate into dollar impacts for at least 3-6 months and even then the rebound in dollar terms is going to be small because we are starting from an extremely low base and because many markets have significant inventory, low prices etc that will stop the rebound being a broad based one.

For more detail on the figures graphed above see http://www.calculatedriskblog.com/2009/03/housing-starts-rebound.html

What chance a US depression - update

A couple of weeeks ago I did some back of the envelop calculations on what the likelihood of a depression (as defined by a > 10% drop in real GDP) is in the US. I concluded:


"Based on all that I'd guess a 50-80% chance of depression. Let's say a 2 out of 3 chance. Certainly even being optimistic I'd find it hard to argue for a less than 50% chance. That's a scenario worth taking seriously"


Since then I've gone back and looked at various current figures on real GDP and found to my surprise that real GDP has only dropped about 1% since the start of this recession. It has just flat lined for about 15 months. Given this, I now believe it is less likely we're going to suddenly fall off the edge of a cliff and have a 10% plus GDP fall from here. So I'd say that given the impact of simultaneous crashes in stock and housing markets along with a financial crisis the powers that be have done a pretty good job at avoiding a real crash in real GDP (though a real bad job in piling up problems for the future and bailing out the undeserving and increasing the likelihood of 10 bad years ahead).

So what's my new guess on the probability of a US depression? Probably 50% maximum maybe a little lower.

On a more practical level I also suggested various actions that may help protect people from the consequences of economic deterioration ahead. Whether we have a depression or a long drawn out period of low growth these actions remain sensible steps in my view.

"1. Save money by finding things you enjoy that don't cost money rather than things that cost a significant amount of money.

2. Give some thought to what you would do if things go wrong for you or your family. e.g. you loose your job and can't find another one, can't get credit, house prices stay down or go lower, stocks stay down or go lower etc.

3. Give some thought to how you might help others if things turn out badly for them. It feels good to help others - here's our chance.
4. Don't go rushing out to buy houses, stocks etc unless you can afford to risk loosing a fair bit of that money in the next few years. Of course even in a depression they may go higher than current prices within 5 years, but who knows, things will be clearer later.

5. Reduce debt.

6. If you're a trader like me be prepared to continue to short the market unless there are some clear early signs of recovery. Given the size and nature of current government interventions be prepared for signs that a recovery stalls and we have a double dip recession like in 1981 then 1982/3 and 1929-33 then 1937/8."

Stock trading update - March 7

In late Feb I summarised my strategy as:

"1. Short SP500
2. Continue to short term trade Australian market with small positions.
3. Watch gold and treasuries markets especially around gold at US$1000 resistance. "

Since then I have:
1. Decreased the size of my size of my short position on US market and opened short positions on the following market indexes Spanish (largest position), French and UK. Basically the eastern European credit problem looks like it might be an issue and that on top of the hosing market related issues and economic contraction there was fast or faster than the US. In addition the European Central Bank has much less power than US Federal Reserve to aggressively take supporting action so they are in a more difficult situation if things continue to deteriorate.

This has worked well as the Spanish market is down 9.5% this month while US market only down 5.8% and The UK and French markets down around 6.5%.

2. Dipped my toe into small gold stocks in the Australian market when it looked like gold was strong. I sold most of the positions as the gold price weakened and manged to get out even through some reasonably good short term trading. Gold has now bounced off 900 and if it can hold above 920 there maybe another attempt to break strong resistance at $US1000. I am poised to jump back in if $920 support holds.

3. Doing a little less of my day trading in small cap stocks and managing to make a tiny bit of money in a steadily falling market which is good.

4. Concluded that there is little commercial property going to be built in the US in the next 2-3 years (in contract to the past year which has been fairly normal due to lags in planning/building etc). so looked for suppliers to the commercial property market in the US to short. Couldn't find any that looked ideal so gave up for now. Need to get back to that.

The economic news is basically still more of the same. Insurance stocks now being hit hard. Certainly there is potential for them to be forced to raise a lot of capital given that they invest premiums in the market before they need to pay them back and asset values have dropped across the board.

There is clearly a possibility of a significant bounce at this part if only because markets have dropped so far so fast. In addition residential real estate and banking stocks have dropped so far that more drops from this point probably won't have much impact on the stock market indexes.

So large falls in the short term probably depend on the market coming to believe that:
a. Commercial real estate is some sort of repeat of residential real estate (hope Geithners stress test include defaults from builders on owners in this area - 25% of banks loans)
b. Insurance becoming part 2 of the banking crisis (again based on asset purchases with money that they need to pay back in the future - in this case to policy holders).
c. More panic in credit markets.

If not we could have a bounce despite continuing deterioration in economic conditions.

What odds a depression in the US?

Economist Robert Barro looked at international data on stock market crashes of greater than 25% to see whether they were associated with depressions. He defined a depression as a fall in real GDP of greater than 10%. These depressions lasted on average 4 years. He came up with a 20% probability of a depression based on this data. For more detail see
http://online.wsj.com/article/SB123612575524423967.html

I thought it was an interesting but fairly simplistic approach. Let's do some quick guesstimates based on a wider and more relevant range of data.

1. He just looked at stock prices data and looked at declines of over 25%. Would have been more interested if he looked at declines over say 40% or 50% as we know the current decline is at least that large adn possibly much larger . Presumably you'd get much higher odds of a depression in situations with larger stock price declines. I'd guess he'd get maybe 30-40% odds of depression based on a stock market crash of over 50% - which is where we are now.

2. Also would have been convincing if he'd looked at real estate prices as well. My understanding is that real estate price declines of current levels haven't occured since the great depression in the US so on that basis you'd probably have to give the odds a lot higher than 20%. Given that you're batting 1 for 1 on the impact of large real estate creashes you'd have to say 50%-100% chance of depression but obviously a sample of 1 isn't much of sample.

3. A few months ago I looked at sharp (>30% in real terms) declines in real estate prices over the past 25 years in many countries. What I found was interesting (I haven't got the figures here but from what I remember):

- Finland - depression
- Sweden - avoided depression with prompt action and also no other countries around in trouble
- Asian crisis - data for 6 countries - 5 out of 6 countries depression
- Japan 1990's - 10 years of extremely low growth so don't know if it qualifies as a technical depression but it counts for me
- 6-8 countries just had severe recessions associated with their house price slumps.

On that basis you'd have to say 8/16 equals 50% chance of depression.

It would also seem sensible to add in what we already know about the current situation, as summarised in points 4-6 below.

4. The world wide nature of the current situation means the usual method of exporting your way out of a credit related problem does not exist. If you restricted your data to the periods of worldwide contraction for your large stock market and real estate market situations you're almost certainly going to get much higher odds but it's obviously going to make your data set smaller. On this basis maybe 60-80% chance of depression.

5. We have a simultaneous large fall in the stock market and the resident ail real estate market - having both together rather than just one is going to increase the chance of depression. On this basis maybe 60-80% chance of depression.

6. What do we know currently about this recession:

- it's already had the longest postwar recession
- the banks are still in trouble
- rapid economic contraction at this point in the US and worldwide
- no sign of any turnaround in any major industry
- massive oversupply in residential and commercial property
- the first negative quarter of earnings since 1936
None of this suggests GDP is going to do anything apart from decline fairly rapidly in the next 6 months and that is then getting us pretty close to but probably not quite in depression territory. On that basis say 50-60% chance of depression on the basis of the current situation as we could still turn around before we reach that point.

So, to summarise the above 6 points, my guesses for the chance of a depression (defined by 10% minimum drop in real GDP over an average 4 year period) are:

1. Large stock market crashes - suggests 30-40% chance of depression

2. US large real estate market crashes - suggests 50-100% chance of depression

3. World wide data on large real estate market crashes - suggests 50% chance of depression

4. Worldwide data on large stock market and real estate market crashes that are synchronized with each other around the world - suggests 60-80% chance of depression.

5. Simultaneous large drops in real estate and stock market - suggests 60-80% chance of depression.

6. Looking at the current length, depth and trajectory of the recession so far - suggests 50-60% chance of depression.

Based on all that I'd guess a 50-80% chance of depression. Let's say a 2 out of 3 chance. Certainly even being optimistic I'd find it hard to argue for a less than 50% chance. That's a scenario worth taking seriously.

What are the implications of this.

1. Save money by finding things you enjoy that don't cost money rather than things that cost a significant amount of money.

2. Give some thought to what you would do if things go wrong for you or your family. e.g. you loose your job and can't find another one, can't get credit, house prices stay down or go lower, stocks stay down or go lower etc.

3. Give some thought to how you might help others if things turn out badly for them. It feels good to help others - here's our chance.

4. Don't go rushing out to buy houses, stocks etc unless you can afford to risk loosing a fair bit of that money in the next few years. Of course even in a depression they may go higher than current prices within 5 years, but who knows, things will be clearer later.

5. Reduce debt.

6. If you're a trader like me be prepared to continue to short the market unless there are some clear early signs of recovery. Given the size and nature of current government interventions be prepared for signs that a recovery stalls and we have a double dip recession like in 1981 then 1982/3 and 1929-33 then 1937/8.

If there's no depression what have you lost by taking these actions - very little. Maybe you are a little less wealthy then you would have been but presumably the economy will be OK so you'll be OK as far as making a wage etc.

However, if you choose to assume the best and fail to plan for trouble, you could find yourself in a difficult situation in an economy in which there are few opportunities for improving your financial, job and debt situations.

If China recovers who benefits?

Stocks worldwide had a one day bounce after 2 weeks of strong and consistent losses in most markets. The reason for the bounce – speculation re more China stimulus and on past China stimulus working.

How is China doing economically right now?

China growth last quarter of 2008 was 0%.
1. Indications from other countries about the fist 2 months of this year gives little hope there will be a bounce in economic growth in China this quarter.
2. China has large overcapacity in capital goods at the moment due to a huge buildup on the assumption that economic growth would stay strong worldwide. E.g. in Shanghai at normal yearly leasing rates there are 14 years of supply standing vacant.

So in summary as far as we know China is not growing and has no need for more capital goods – apart from what the government may pump in.

Who will benefit from the Chinese governments stimulus?
1. People with the Chinese government connections – i.e. the Chinese.
2. Suppliers of raw materials – Brazil, Australia.
3. Suppliers of low end goods – other SE Asian countries.

Who will not benefit?

Countries that supply capital goods and high end consumer goods to China – Europe, US etc. China doesn’t need more robots (they have plenty that are standing idle); they don’t want a lot more high end consumer goods (they are seeing contracting rather than growing wealth at this point, same as everywhere else).

What action does this suggest?

If there’s going to be a significant rally in equity prices (say greater than 10%) on the “China will save us” idea then I will
1. Short Europe and US stocks – as the economic data that follows will show the hope was misplaced.
2. To the extent that oil and commodity prices look to be rising in a sustained way and there are signs of growth in China’s economy; I will go long Australian mining and oil stocks.

How could a bank nationalization / reorganisation work?

Misha over at http://globaleconomicanalysis.blogspot.com/2009/02/nationalization-revisited.html had some good questions about US bank nationalisation.

OK my 2 cents worth on what would be a less bad outcome - as opposed to what may happen.

1. Are all US government guarantees of bank debt null and void? They should be. At a minimum, taxpayers are currently on the hook for $300 billion of Citigroup's debt and $100 billion of Bank of America's debt.
Answer- Yes guarantees null and void for banks restructured. Let them bid for company if they think the debt is worth more than the money buyer’s offers for the assets.

2. Are we going to end up creating another banks that is "too big to fail" out of this mess?
Answer- Possibly depends who well sell them off to - how about selling bit off to different bidders (I would assume they are current better managed and solvent banks) depending on what they want and what they're willing to pay

3. Will stock holders and preferred shareholders both be wiped out?
Answer - Stock holders - yes wiped out - they would have already been so if not for government intervention. Preferred - depends on what you sell it for just like bankruptcy - if asset values don't cover debt as is likely then then wiped out.

4. In a normal bankruptcy process one might expect to see significant changes in management. Will the nationalization process allow the clowns who wrecked these banks to stay in control? For how long? Under what capacity? And what person or committee gets to decide those questions?
Answer- You sack the head honchos to start with - you sell off the parts, who keeps their jobs depends on the new owners, they presumably will be cutting.

5. Will the CDS liabilities be wiped out in entirety regardless of consequences? Clearly they should because otherwise taxpayers will be footing the bill. Unless this is spelled out I suspect measures will be taken to protect Goldman or whoever else is on the right side of those CDS and derivative contracts.
Answer- I don't understand the logic about canceling existing contracts other than it was an unregulated market out of control and it's costing the relevant parties an incredible amount of money. Canceling contracts selectively on this scale sounds a dangerous precedent.

6. What kind of bidding process will be put in place and in what time frame for the assets of the banks? Who decides and why?
Answer - Bigger scale suggests it may take longer than normal FDIC workout. That's why you need some extra government involvement. I don't know if this means 1 week or 1 year. In the interim the government body responsible (FDIC+help) takes control but you do business as usual (well usual in a sane world).

Summary
The way I see it you go as close to the best current model that actually works in the real world in the US (i.e. FDIC workout) and beef it up and give it more time so the scale isn't such an issue. If you try something new you don't know what may go wrong.

In addition get in there and investigate and make a few prosecutions where management has been negligent or dishonest. This serves both for moral hazard purposes and makes taxpayers feel better for making up any shortfall on the asset sale.

Stock markets - medium term trends

I blogged here http://reflexivityfinance.blogspot.com/2009_01_01_archive.html exactly one month ago on January 18 about where I see international equity markets going in the next 3-12 months. I concluded then that..

"So in summary, the all the balance of probabilities is for more downside in stock markets all over the world for at least the next 6 months and possibly considerably longer.In a word if you're a trader - short . If you're an investor I would dump companies that have a lot of debt (even if prices are fire sale it's better than holding on while they go bust) and stay away from the banks and finance companies, commercial property and builders that are directly exposed to the largest problem areas. Personally I'm short the SP500 index in the US and 85% cash and only 15 % invested in stocks in (this is my primary home market Australia). Most of these stocks are held based on a strategy of buying stocks that are trading at a 30% plus discount to their marked-to-market net asset value (a Buffet type strategy) and have no debt. Generally I try to to be 90% invested in the stock market so here actions speak louder than words."

So how are things panning out?

Let's look at some major countries equity markets performances over the last month since I posted.
1. US - SP500 - down 8%
2. Germany - DAX - down 1%
3. UK - FTSE100 - Down 5%
4. France - CAC40 - down 1%
5. Japan - Nikki 225 - Down 10%
5. Australia - my home market - flat

So basically being short the SP500 has been a good choice the US has been one of the weakest big markets over the period. Not being heavily in the Australian market hasn't hurt me. I've made a little money on short term trades there with minimum risk. I'm now down to 10% invested in the Australian market after closing out some fundamental trades that aren't going anywhere anytime soon. There was a small rally in early February in most markets but this has died now.

Also the areas I identified as having most downside - builders, banks, other financials, commercial property - all down significantly more than the index in the US and here in Australia. Not sure about elsewhere but guess it would be similar.

So have there been any significant changes in the 9 factors I looked at in January? Not many. Taxpayers money still being put into stimulus packages or associated bailouts. Economic news still gloomy and getting gloomier - particularly in terms of contractions in international trade. Prices still too high compared with earnings and asset values, long term technical trends clearly still down etc. Possibly the one thing that appears to be changing is that the US market is not rallying as hard on stimulus and bailout plans - the faith in magic fixes is waning. As that was the main source of positive short term moves in the market that tends to make the case for being short stronger.

The one real change has been the strength of gold stocks. This bares watching both as a trading
opportunity and as an indication of the loss of confidence in US treasures as a safe haven or due to inflation fears based on government debt and the desire to inflate it away in the future. So far I have only traded gold stocks short term. However if gold gets past strong resistance at US $1000 I plan to buy gold stocks and look to short US treasuries.

So the strategy is:
1. Short SP500
2. Continue to short term trade Australian market with small positions.
3. Watch gold and treasuries markets especially around gold at US$1000 resistance.

US recession - Febuary update - still bad

In January I blogged about a graph on US employment comparing all postwar recessions. My thoughts basically came down to - "So employment held up well early but it’s going to get uglier than in living memory and looks like living up to the “worst post war recession” hype." "

See the updated graph for the Federal Reserve here.
http://www.minneapolisfed.org/publications_papers/studies/recession_perspective/index.cfm

Basically employment continues to worsen at the same rate as the previous few months as I expected so things still look grim.

Interestingly the other graphs on the link above also show that output actually kept growing during the early stage of the recession - this has a lot to do with countries the US exports still having good growth up to mid 2008 and this coupled with the low US dollar meant US exports were still booming up to mid 2008. As the recession has spread worldwide, and the US dollar rallied, this export boom has turned around dramatically so output in now decreasing.

The longest USA post WWII recession has been 16 months. So far this one has lasted 13 months and so there is little doubt that this one will be longer. It also seems likely that the decrease in employment will be higher than any other post WWII recession. This is troubling as it suggests a somewhat different (and more damaging) dynamic in this recession than other recessions. The global nature of this recession is no doubt a large part of this and a negative for the short term while the twin consumer and government debt burdens are also troubling from a medium to longer term perspective.

Given unemployment started from a low level there is some hope it may not peak at much above 10% which at least gives some hope for a situation that may not be too disastrous in terms of people's lives and social cohesion even if output growth is slow after the recession and unemployment fails to decrease for some years.

Bank bailout - risky plan - macroeconomic scanarios

I number of commentators have called for the temporary nationalisation of insolvent banks rather than the current approach. These include those who saw the crisis coming such as Robinini and Soros. The people that said there wasn't a problem (Paulsen, Bernake and now Geithner) now say the problem can be fixed but without radical changes in approach to the ones that have so far failed to address the underlying issues. I believe this approach is to risky to be the one relied upon. Too risky for the for the US and world economy in the medium term.

At the moment the plan is basically to:
- provide government, loans and capital but keep banks in private hands,
- facilitate mergers as more solvent banks buy less solvent ones (often with government of Fed guarantees against losses),
- try and encourage private investors to buy the risky bad assets off banks by limiting the downside by providing government guarantees if things get worse etc.
Basically socialising the losses.

There are a number of other parties that could be bought to the table to assist before the government is required to tip[ in more capital. At the very least pressure needs to be bought on other relevant parties: management, creditors, stockholders and employees to come to the party before funds are provided. This is the usual approach when a company is insolvent and this is what banks do to their customers all the time. They need a stick to do this - usually this stick is bankruptcy. This appears too risky in this situation so the stick needs to be nationalisation.

The financial stress test that decides nationalisation is supposed to be forward looking. If so it would need to take into account:
- housing prices are going to continue to go down in the foreseeable future and then in 1 year all those ARM's reset and there's another 2 years of foreclosures based on that
- companies are going to start going into Chapter 11 as the recession goes for longer
- unemployment is likely to be higher rather than lower

It seems unlikely that many banks would pass such a stress test so presumably the banks will be pressing for a less stressful and transparent stress test that they can pass. Then when things get worse they can say it wasn't our fault the government checked us out we were just unlucky that things got worse, and can we have some more money please.

The big risk of the current approach is that if things continue to get worse despite this plan the government is in a much weaker position to go the nationalization route. You then risk the loss of US dollar safe haven status. This means a drying up of loans for treasuries and either mass insolvency for the banking system or the Fed having to print money. As presumably the Fed would print money we would then have high inflation and high interest rates to go with the high inflation. The impact of high interest rates would drive down already depressed asset prices and weakened corporations etc. It's a whole other reflexive (ie. self reinforcing) cycle) down. Then we do have something like great depression II.

Taking too much risk is what got everyone into this mess. Temporary nationalization of US banks might be less palatable in the short term but it takes much of this big risk away.

Gold prices have rallied strongly on the current Geithner plan suggesting other also see loss of US dollar reserve status is real risk in the medium term. So what are the broad macro economic scenarios going forward.

1. Best case. The plan works well (or they bit the bullet and go down the nationalisation path)along with other stimulus and banking bailout plans worldwide. The world resumes solid growth in 12-18 months. Obviously the banking systems still got some issues and governments have large debts but nothing some gradual inflation and fairly low real interest rates can't fix over 5-10 years. Presumably China and India come out of this stronger than US and Europe and the opportunities are more in developing countries as the US and Europe have to stop leveraging up.

2. Deflation case. After the US come out of negative growth there's Japan 1990's style 8-12 years of slow growth, continued asset price deflation and high unemployment.

3. Inflation case. Scarier option of high inflation, double dip severe recession and loss of confidence in US dollar if the US dollar looses safe haven status and Fed has to print money and so inflates. A lot of turmoil in currency markets as countries unpeg from dollar.

As far as what this means for asset prices.
A. Stock prices
- Best case is OK but probably no turnaround within 6 months so no hurry to be in the market. Worth watching to see which countries markets/sectors look stronger as if there is a new bull market in the next few years its' dynamic will be very different to the last one.
- Deflation case is bad for stock prices.
- Inflation case - gold stocks the obvious pick

B. Commodity prices
- Best case OK for commodity prices particularly if China and India are the stronger economies
- Deflation case - bad for commodity prices
- Inflation case - good for commodity prices

C. Gold
- Best case - bad
- Deflation case - bad
- Inflation case - very good

So no change to my general conclusion that it still makes sense to be short stocks and to have plenty of cash and to watch how things play out. Each scanario leads to radically different conclusions.

Defaults on government debt - starting now?

Economist Brad Delong has put together an excellent compendium of academic papers to illustrate the history and relevance of past financial crisis. http://delong.typepad.com/sdj/2009/01/financial-crises-in-historical-perspective.html

The one I found most interesting wasn't on the list "This time it's different - A panoramic view of 8 centuries of financial crisis." http://www.economics.harvard.edu/faculty/rogoff/files/This_Time_Is_Different.pdf

This long (125 page) paper looks mainly at sovereign debt defaults. The following summarises my reading of it and it’s relevance for the current situation.

1. Very high default rates across all regions in all time periods apart from short lulls of a decade or two.
2. In situations were gov debt is domestic rather than external there is still default on external debt - this seems contrary with IMF views.
3. Defaults in countries happen in waves and generally flow big decreases in commodity prices that impact these "emerging
“Economies.
4. There are also peaks in defaults after there have been large financial flows from eh financial centers to the "emerging" economies. I.e. the money is spent then the flow stops and then the defaults occur.
5. There is particularly high inflation in the defaulting countries during and after defaults. I.e. the gov inflates to reduce indebtness
6. Inflation crises and exchange rate crisis go hand in hand.

To me, the current situation is a classic illustration of a typical scenario just before a large wave of defaults occur. I.e we have had the prerequisite large capital inflows (which are now rapidly drying up or reversing) and the collapse of commodity prices. The fact that much of the debt is local rather than external is no protection.

This also suggests we are going to have high inflation and big drops in exchange rates in the emerging commodities that have been impacted.

The difference this time seems to be that the largest capital flows have been into what most would consider the financial centre (US). This may change the dynamics of things but I don't think it will change the sovereign debt defaults in many emerging markets.

If this does occur this is going to cause:
1. Serious stresses on governments in non defaulting countries supporting bailout efforts in other countries through the IMF etc
2. Defaulting countries will be unable to support their own economies during the current downturn – indeed the usually proscribed austerity packages will exacerbate the issues given the global downturn and the difficulty of exporting your way out of the crisis when export markets are very weak.
3. Geopolitical tensions, due to the battle between debtors and creditors over repayment schedules, austerity packages etc.
4. Political instability in defaulting nations.
5. Further strains on the solvency of the banking systems in a wide range of countries (US Europe Asia etc) as more bad loans are written off.
6. A great deal of suffering in countries with high poverty levels.

Clearly a rather worrying picture on top of the current problems in private markets.

From a trading perspective the best options here would appear to be to short emerging currencies that have significant government debt and "commodity" exports over the coming few years. I'll talk more about the implications of this and any early signs of a wave of defaults occurring in a follow up blog.

Misconception 3 – Easy credit caused the housing boom

This one is more an oversimplification than a misconception.

There have been very similar credit conditions across all housing markets in the US. However vast differences in changes in price by city/ region. So while easy credit conditions during the boom certainly had a significant impact they are only one part the whole story. The economic literature and my 5 years experience studying speculative forces in housing markets suggest the following factors.
- Local economic growth rates
- Housing supply restrictions
- Expectations based on local past experience

Economic growth rates (and the associated changes in wages, economic migration, employment etc) make a significant difference in the demand for housing. We can see this most dramatically in looking at house price figures for a city like Detroit where house prices have been decreasing in real terms for many years due to a decline in their traditional industries and a subsequent migration out of the city. Fundamental economic factors are likely to have been at work to early in the booms in growth areas in the Sunbelt.

Supply restrictions on land and building are also likely to have resulted in the inability of the market to quickly supply relatively affordable housing and stop prices from increasing quickly as demand increased. See http://www.demographia.com/dhi.pdf for a detailed international perspective. This study shows booms in prices across hundreds of cities worldwide overwhelmingly occurred only in cities with relatively tight planning restrictions.

Studies of what investors and home buyers expect to happen to house prices in a particular housing market indicate that most people project recent past prices changes (over the past year or two) into the foreseeable future. So once prices begin to discernibly rise potential buyers scramble to buy quickly before prices rise further. They are willing to buy at prices greater than similar homes have recently sold for as they believe prices will be higher still in the future. Without this factor house prices will generally appreciate only slowly as buyers and sellers are looking at prices of similar properties in deciding a reasonable price to buy and sell. Once prices stop rising potential buyers stop believing that prices are going to continue to rise in the short term and the bust begins.

How can this knowledge help policy makers? Clearly once a boom has run it is largely to late for policy makers to contain damage such as:
- builders having built houses that people do not want to buy
- investors/home owners financially overstretched
- banks and others find their loans are not being repaid and the loan is worth more than the collateral

1. As booms are local phenomenon the use of broad nationwide monetary instruments (e.g. interest rates) or fiscal policies (e.g. incentives to homeowners/builders) is not advisable.

2. Supply side restrictions need to be decreased as much as possible so affordable housing enters the market in a timely manner.

3. Decrease unrealistic expectations about future house prices. This requires the provision of strong public education through all available channels to dampen down unwarranted speculation based on unrealistic expectations. Channels could include media, industry groups, investment advisers etc. Furthermore a government pre commitment to take credible actions to decrease prices in speculative bubbles would send a message that the boom will swiftly end and make the educational message more credible. Such commitment could include temporarily increased taxes on capital gains from housing, or swift decreases in restrictions on supply in the case of increased prices.

4. However, perhaps the most effective deterrent to future housing bubbles is simply to let this bubble deflate without the kind of support which will stop prices from returning to more realistic and normal levels. House prices in many markets are still far above pre boom levels and well above historical levels when compared with incomes or rents. To stop house prices from returning to economically sustainable levels would be:

- expensive

- unfair to those who have not benefited from the previous boom and

- counter productive; as without expensive and ongoing artificial support prices will still fall at a later date and the lessons of the boom and bust would not have been learnt thoroughly enough to prevent a repeat.

How can this knowledge help homeowner and investors?

1. If you live/own in a market that has had a large boom and have equity in your home and selling is an option you would consider then it's probably better to sell now then wait for a few years and sell at lower prices. this is particularly so if you currently have some equity in your home but might be forced into foreclosure (and hence loose all your equity in the house) at a later date.

2. If you're renting and looking to buy in a city that has boomed and boom prices are well above what they were before the boom began then there is no hurry as houses will probably be significantly cheaper in the coming years.

3. If in the future you see people making a lot of money by investing in housing (or anything else) during a boom time - don't be panicked into buying or think this is the way to make easy money . The boom will end and those that made a lot of money will probably loose a lot of money. In the long term the price of housing will remain in line with rents and prices. We don't' know who long it will take this to happen -sometimes prices zoom back down in two years and sometimes it takes 15 years of house prices standing still while inflation and increases in real wages catch up.

For an excellent source of both insight and data from an international perceptive see http://www.jensks.com/

Misconception 2 – Housing market inventory

Misconception 2 – Housing markets won’t recover until the inventory is gone

Once we accept the idea that there are lots of separate housing markets rather than one market (see my blog "Misconception 1 - One Housing Market") it’s clear that the huge amount of inventory of unsold homes in one market doesn’t mean much for another market. So there could still be a huge backlog of inventory in many markets while other markets may need new supply. i.e. those with reasonable economic growth, no huge backlog of inventory and affordable housing.

This is good news for builders and residential housing market investors in these areas. For stock market traders/investors this suggests it will be highly profitable in the coming year or two to buy beaten down builders who are active in stabilising housing markets. Don't be put off by headlines about inventory gluts and falling prices in "the housing market".

However there is bad news for investors in markets with a big overhang of inventory and for holders of CDO’s and other housing market debt that was issued based on these markets. The real value of these (either in an auction or on a “hold to maturity basis) will most likely continue to drop as prices continue to fall and as foreclosures continue to mount. This bad news for the solvency of the financial system in the year ahead.

Misconception 1 – One housing market

I spent 5 years writing a thesis on speculative forces in residential housing markets and will do a series of blogs on misconception and reality in the US housing markets.

The mainstream media and politicians often talks about the housing market as if it’s one single market. While for some purposes there is a grain of truth in this, for most purposes this is downright misleading.

Let's start by thinking about what a "market" is. A market is made up of goods that are reasonably close substitutes for one another. However while houses are similar in some ways (they all have walls, roofs, provide shelter etc) houses in one city/region are not generally substitutes for those in another city/region and often even within a particular city it can be more useful to think of a lot of loosely connected separate markets than one market. This range of local markets is primarily due to three things: location, housing type and housing quality.

Location - If I’m looking for a house in New York a house in LA isn’t much good to me no matter how much the price falls.
Type - If I’m looking for suburban house for myself, my wife, three kids and a dog a condo probably isn’t for me.
Quality – if I can afford a house in the price range $175-200K a house worth $500 K isn’t relevant to me.

What we see at the moment is a some similarity among housing markets across the US (i.e. prices are generally going down) and then significant differences between cities/regions and even within cities/regions between housing types and housing quality.

Looking at house price by city/region. Those that went up the most generally coming down the most. For example, prices in LA and Miami boomed around 175% between 2000 and mid 2006 and are now down nearly 40% from their peak while in cities like Denver, Charlotte and Dallas prices only rose 25-40% during that same period and have only come down 5-10%. For detailed data http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html It appears houses prices are steadily coming back to historically "normal" levels compared to incomes and rents. So probably some considerable way to fall in the boom cities.

Even within the same city/region there are wide discrepancies in how properties in different price ranges (quality) or type are selling. While reliable statistics for these are harder to come by (due to small sample sizes) the real estate agents and buyers and sellers on the ground are well aware of this.

Brett Steenbarger looks at months of housing inventory/sales for three different price ranges in the city he lives in (Naperville, IL). http://traderfeed.blogspot.com/2009/01/more-evidence-of-lumpiness-in-housing.html He concludes “There is little inventory problem at the lower end of the housing spectrum; speculation in that market had centered on the luxury end, where there is more than 3 years of inventory…. In my looks at other suburban communities, from Washington to Florida, I have seen similar lumpiness in inventory.”

Here Brett looks at a wider view across both cities and housing types
http://traderfeed.blogspot.com/2008/07/localized-housing-bubbles-distribution.html
Again, there is huge variation across different types of housing in the same city and also obviously between cities.

For a more comprehensive view based on the Case Shiller housing market indices see:
http://www2.standardandpoors.com/spf/pdf/index/Case-Shiller_Housing_Whitepaper_YearinReview.pdf
They show that prices changes for different types of houses (condo's versus single family homes) and price levels (i.e. quality) have varied significantly. Again markets

There are a large number of investors on housing market blogs who are saying “all markets are local” and they are right. However they area also saying “my market is fine”. Obviously for some of them this is the case but given the state of most markets this is probably more the exception than the rule.

At the same time politicians and their advisers are in the midst of a trying out and planning a wide range of actions to stabilise "the housing market". If these policies are based on the idea of a single market they are bound to have some very unsatisfactory and unwanted results.

In the case of both investors and politicians it appears that self delusion is a powerful force.

Risk, Uncertainty and the Financial Crisis

The concept of reflexivity (see blog on reflexivity and finance for explanation) has an important implication for theories about financial markets in general and also for the current financial crisis.

This implication is that markets exist in historical time where events and situations are to some extent unique and not simply part of some timeless economic machine in which financial outcomes (e.g. the probability distribution of returns in markets) are unchanging and fixed. So there exists not only risk (the range of probabilities of outcomes indicated by past events) but also genuine uncertainty (the impossibility of knowing what the future holds even in a probabilistic sense). This is important for the formation and testing of economic/finance theories because it means:

1. The expectations and actions of markets must be conceived to rely on something other than the accurate calculation of probabilities about the future. e.g. social convention, personal experience, expert opinion.

2. That theories about economics and finance may be more relevant for some segments of historical time than others.

Uncertainty is important for practitioners in financial markets because players in these markets need to be aware that calculations of probabilities based on past history maybe radically inaccurate. Failure to understand this contributed to the proliferation of financial instruments that investment banks and other produced in the belief that the data on which their models of risk and return would remain stable over time. As taught by standard approaches to finance. Sadly practitioners did not recognise uncertainty and as the the dynamics of the economic situation turned their calculations proved to be disastrously inaccurate and lead to the technical insolvency of much of the global finance system. This episode will surely go down in history as one of the most disastrous misconceptions of the last fifty years. The ironic thing is that this mistake was made by thousands of the most intelligent people on the planet. Such are the dangers of building an edifice of knowledge on an inaccurate assumption and then leveraging your bets.

Reflexivity in financial markets: its meaning and implications

Reflexivity is an idea that has a long history and has been applied in many social sciences.


However in the finance areas the term reflexivity has been popularised largely by one man, George Soros.


The basic idea is that:

1. The market is made up of people.

2. People have a conception of the economic reality (which is inevitably false or incomplete) and base their actions on these conceptions.

3. These conceptions then have a feedback loop with "economic fundamentals"..

4. In certain historical circumstances this feedback loop leads to outcomes that are initially self fulfilling but inevitably self defeating in a boom/bust sequence.

5. Generally this reflexive boom/bust sequence initially builds on a pre-existing trend based on sound economic fundamentals.

Examples of factors that may give rise to this the feedback loop in point 4 include

(a) increasing lending against appreciating assets without understanding that one of the main reasons for the increased asset price is the increased lending.

(b) the trend-following habits of investors or speculators (including adaptive expectations formation).


A current example of reflexivity in modern financial markets is that of the debt and equity of housing markets. I would argue that both the factors (a) and (b) above contributed to this damaging boom bust cycle in the following way.


a. Lenders began to make more money available to more people in the 1990s to buy houses. More people bought houses with this larger amount of money, thus increasing the prices of these houses. Lenders looked at their balance sheets which not only showed that they had made more loans, but that their equity backing the loans - the value of the houses, had gone up (because more money was chasing almost the same amount of housing). Thus they lent out more money because their balance sheets looked good, and prices went up more, and they lent more, etc. Prices increased rapidly, and lending standards were relaxed.

b. Ever larger numbers of potential investors in housing markets grew increasingly confident that house prices would continue to increase based on their past experience (i.e. adaptive expectations) and thus scrambled to bid up the prices of houses.

Reflexivity in simply an inescapable fact of life in all arenas of social action. The reflexive boom/bust sequence is one consequence of this and only occurs in certain historical settings. In this conception financial markets are not necessarily in, or indeed close to, equilibrium.

Soros perspective is that the housing boom and bust has been superimposed on a larger global "super bubble" for that last 25-30 years. This super bubble is base on so called global "market fundamentalism" regarding financial markets. i.e the belief that free financial markets work well and when left to their own devices tend towards equilibrium. This belief lead to three main trends: (a) unchecked credit expansion, (b) an explosion in the value and type of unregulated financial instruments (derivatives, leveraged instruments, securitised instruments, synthetic instruments etc.), (c) globalization of financial markets with the financing of US consumption (private and government) by foreign lenders (China etc). This bubble has now burst and we are now in the beginning of the bust phase. Given that the boom took 25 years to unfold I would not be surprised if the bust lasts more than a year or two.

For more information on the broad idea of reflexivity see the follows chapter from a book on the reflexivity http://www.springer.com/cda/content/document/cda_downloaddocument/9783790820911-c1.pdf?SGWID=0-0-45-624115-p173844610.

For more information on George Soros and his thoughts on reflexivity and the current financial crisis see http://www.georgesoros.com/.

Is this an unusually bad US recession?

The above following chart present an interesting comparison of our current U.S. recession’s percent change in employment with those of the 10 previous recessions that have occurred since 1946.

Thanks to Michael Guzzo from http://guzzothecontrarian.com/ for bringing this data to my attention.

So on face value it looks like this U.S. recession is pretty well a median type recession so far. Until you look more closely.

Clearly employment has shrunk very slowly in the first months of this recession meaning, from this perspective, it looks much like a “median” recession. However, look at the rate of change in employment in the last 6 months - its rate of fall is much faster than earlier and this rate is accelerating.

Also worth bearing in mind that employment is probably a 3-6 month lagging indicator compared to say real GDP or retail sales and that retail sales have been decreasing 2-3% a month (yes a month!) for the last three months and that this rate of decrease is also accelerating. For more detail on retail sales see http://www.rgemonitor.com/us-monitor/255122/retail_sales_fall_98. So given employment’s lag we should expect the employment to keep falling at the current rate or faster for at least 3-6 months even if retail sales turned around in January. Given that that rate of change in retail sales or real GDP is inevitably not going to turn positive in the next 3 months and probably not for at least 6 months (and possibly much longer though stimulus will give some positive bumps) we’re looking at a that employment graph heading south at the current rate of decline for 6 to 12 months. That will take the current decline in employment to worse than the harshest recessions on this graph in terms of total loss of employment. It will also mean the length of time from the start of recession until it begins to sustainably turn around (maybe somewhere between months 21 and 27 on that graph) would be much longer than longest post war recession.

In the two most recent recessions the unemployment rate actually peaked around 15 months behind real GDP so if that pattern continues it's even worse. So employment held up well early but it’s going to get uglier than in living memory and looks like living up to the “worst post war recession” hype. Having said this anyone suggesting this is great depression number II is merely speculating rather than looking at the facts . The great depression was 4 years long and involved a massive 50% decrease in GDP and was simply a bigger beast altogether than either the recessions since the WWII or the 15 contractions in real GDP that occurred from 1840 to 1920. Indeed the fact that we had the great depression has meant that policy makers and economists have to some extent learned from it. So what happens from here it will be ugly but it will have a somewhat different dynamic that the great depression.

International stock markets markets - where to from here

Many countries around the world are in a recession (one that will most likely get a lot uglier in terms unemployment, poverty and social unrest) and we've had major stock markets busts in every major market. I summarise what past studies and current data tell us about how things are likely to play out in stock markets around the globe. Given economic data and economic theories and forecasts are always flawed (inaccurate, incomplete, irrelevant etc) I find the best way is to take a wide range of perspectives to get an overview and avoid basing my thoughts on one shaking bit of data or one perspective.

A. Let's start by thinking at which equity markets matter and if it's really meaningful to talk about a global equity market, as opposed to a whole lot of country specific equity markets. In recessions most equity markets around the world tend to have much higher correlations with each other than they usually do (i.e especially when there are in sync recessions as is the case at the moment). So at the moment and in the medium term we can meaningfully talk about a global equity market. This means that any question about who a stock market will perform in one market is tied up to the question of how the whole current global crisis will play out. The US is the largest economy in the world and also leading the pack in terms of timing of real impacts on the economy so is probably the most relevant place to study. At the moment it seems the initial crisis stage in the debt markets have passed due to actions by the Federal reserve and others in propping up the debt markets. For relevant indicators see ttp://www.nytimes.com/interactive/2008/10/08/business/economy/20081008-credit-chart-graphic.html.

However in most vital areas of the USA real economy (e.g. housing markets, retail sales, and unemployment) things are not only getting worse but the rate of deterioration is increasing. Indexes of leading indicators are also pointing down. Before things actually get better in the real economy the chronological steps we have to go through are:

1. Stop increasing the speed of deterioration
2. Continue to get worse but at a slower pace
3. Stabilise
4. Start to improve.

It's hard to see all these steps occurring within a time frame of less than a year . Indeed to may take it may take a number of years and be an L shaped recession. i.e. a protracted period of economic stagnation like the one experienced by Japan in the 1990s after the bursting of its housing and equity bubble So as far as the real economy in the USA is concerned it's going to be a while before things turn around. Other countries are just now entering in recessions so they may even come out of recessions after the USA.

B. The scope of government action. The decrease in real GDP has occurred despite large stimulus and bank bailout measures and unprecedented monetary policy action. So there is not too so much more the governments can do without causing themselves significant long term problems (i.e. government deficits become to large for markets to believe they will be serviced and the Fed ends up lacking creditworthiness due to holding assists worth less than amounts lent).

OK so that's the real economy but hasn't the stock market already fallen a lot and discounted these problems meaning we might have seen the bottom?

C. When in the economic cycle are equity returns usually strong? Research indicates that returns in stock markets are very high for 6 months starting in the last 6 months of recession or at the end of recession. So given we're very likely more than 6 months away from the end, and possibly years away, this suggests we should be vigilant for a possible stabilisation in the recession (particularly if its' not related to one off government stimulus responses which will have a temporary impact) but we shouldn't be too hopeful about strong equity returns from this point.

D. Are stocks cheap compared to earnings? Aggregation of earnings forecasts suggests that when looking at individual companies USA equity market earnings forecasts are way too optimistic given the bleak macro economic outlook. i.e. analysts forecasts are suggesting earnings will zoom up over the next year when clearly the economy looks tougher this year than last. Earning disappointments will lead to disillusion with the market and create strong downward pressure on prices.

E. Are equity prices cheap compared to the asset values of the companies? Compared to valuation during the last few years yes prices are cheap compared to asset value. But historical standards during recessions equity prices are not cheap. Tobin's Q - The measure of equity prices to prices on assets on the books - is currently around 0.7 this typically bottom's at 0.3 during recessions. This suggests there is a long way to fall. i.e. over 50%.

F. Are longer term technical indicators basing in preparation for a sustained rebound? Primary long term trends in all major stock markets are clearly down.

G. What is driving equity term markets on a daily basis and does this gives us hope? Looking at the past 9 months the pattern in movement in daily stock prices is astoundingly consistent. Equity markets are rebounding based on possible government actions and falling on the reality of earnings and broader economic data. There is no other "story" of substance out there in the market. Given the size of the economic problem, governments cannot have an overwhelming impact. So once the reality of this hits the primarily stimulus in this market of this "Obama bounce" will be gone and traders will be focused on the bleak macro economic data and the bleak earnings data.

H. Will the new administration in the US make a difference? Sure they can take actions that will have positive impacts but they are still politicians in the same political, social, cultural and economic system and political/equity cycles suggest bad times ahead. Basically "on average" equity markets in the US perform well in the third and forth years of a presidential term and poorly in the first and the second years. My understanding of this is that in the third and forth years most presidents (and congress and the senate) worry about being elected next time so they need to get out there and sell a positive picture of the economy. However during the first two years they face the reality of not being able to fund all their promises and the opportunity to talk down things and blame their predecessor. No doubt Obama will "discover" things are a lot worse than he thought and he will not be able to follow through with campaign promises.

I. Buffet is buying so if I'm a long term investor isn't now the time to snap up some bargains? Yes Buffet has been buying (but generally getting a special deal rather than buying at market price as you would be). His interviews suggest he's buying based on his view that this is largely similar recession to the ones he has experienced since he started in 1954. There are two points here. One - this recession looks different in terms of the: possible insolvency of the banking system, the debt levels of the USA consumers and government and the massive bubble in house prices that still has a long way to bust . Two - Buffet doesn't try to time the market, he readily admits he usually buys in too early when the market falls and he buys stocks with very specific characteristics rather than the whole market (often at prices unavailable to others).

So in summary, the all the balance of probabilities is for more downside in stock markets all over the world for at least the next 6 months and possibly considerably longer.

In a word if you're a trader - short . If you're an investor I would dump companies that have a lot of debt (even if prices are fire sale it's better than holding on while they go bust) and stay away from the banks and finance companies, commercial property and builders that are directly exposed to the largest problem areas. Personally I'm short the SP500 index in the US and 85% cash and only 15 % invested in stocks in (this is my primary home market Australia). Most of these stocks are held based on a strategy of buying stocks that are trading at a 30% plus discount to their marked-to-market net asset value (a Buffet type strategy) and have no debt. Generally I try to to be 90% invested in the stock market so here actions speak louder than words.

Why this blog?

I want to connect with people who have overlapping interests with me. For example those who have an interest in the approaches of George Soros, or behavioural economics, or who simply have practical insights from their experience of trading financial markets. Ultimately I aim to work with George Soros and Robert Shiller. So if you've got an interest please contact me, reference me in your blogs, comment and/or direct me to others who maybe interested!

I want to connect with with people who are interested in the study of financial markets because I believe there is a better way for academics, regulators and finance industry participants to understand and study financial markets then the standards methods based around the efficient markets hypothesis. I call this approach "Evidence Based Finance Economics". It means that approaches to financial markets should seek to encompass as much evidence as possible. This evidence includes both the currently studied macro level changes in prices and volumes and as well as the currently ignored micro based evidence on market participants portfolio allocations and decision making processes. This vastly broader set of evidence enables us to both come up with insights that are relevant to individual market participants (as opposed to "the market") as well as continually improve our macro theories and understand the limits to our theories. i.e. understand where our theories apply, how accurate they can be, what aspects of reality are more or less stable over time and which ones may change over time etc.

I believe that because the current approach restricts it's approach to "The Market" is a theoretical dead end that provides little scope for improvement in current theories. The lack of progress in the mainstream study of financial markets over the past 25 years and the complete surprise of economists at the occurrence current financial crisis bears this out.

How did I come to my beliefs?

In a sense this blog begins to complete a circle in my study of financial economics from theory to practical experience and now back to theory. From 12 years from the age of 18 I comprehensively studied the academic and professional literature on financial economics, as well as what I took to be relevant in psychology, philosophy and sociology. During this time I wrote a 250 page long masters thesis that looked at theoretical approaches to expectations formation in asset markets and at the evidence for expectations formation in housing markets. This evidence strongly suggested to me that peoples expectations about future house prices are generally trend following based on the recent (1-3 years) of changes in house prices in the areas in which they live. I was surprised that my approach (looking at a wide range of evidence and seeking to evaluate how various economists insights about expectations formation apply to housing markets) was met with an angry reaction by most academic economists. I was admonished to use the standard and approach and restrict the evidence I looked at to the standard macro economic evidence. The head of my department at the university finally explained to me that academics were not really interested in original research from master students they wanted you to follow the standard recipes. Had he told me this at the start of my thesis it may have saved me 5 years of working on an approach that was never going to be accepted.

I concluded that despite my strong desire to contribute to the study of financial markets a career as an academic economist at this point was virtually impossible unless I simply conformed to the standard methods that I believed to be deeply flawed. So at this point I decided the only way to really show people that I had insights into financial markets was to take my own money and speculate successfully in these markets. This I have now done successfully for ten years.


Why do theories about financial markets matter?

At the broad level they matter if you want the world to be a better place to live where people can make sensible financial decisions that are likely to lead to prosperity rather than disaster and where regulators have a good enough understanding of these markets to enable appropriate regulation. Given the current financial crisis, it's unfolding impact on people's lives and the past and present actions of regulators there is great scope for improvement..

Where to from here?

To paraphrase a private detective movie character. If you're looking for one particular thing it's hard to find it - because of all the things in the world. But if you're looking for anything interesting you will find it - because of all the things in the world.

So approach here is simply to blog about things that I believe are interesting about financial markets and how they are studied. Some of this will be drawn from the academic literature, some of it from other interesting commentators and some of it from my own study of financial markets.

I'll blog about once a week and look forward to hearing from you!