Thursday, August 17, 2006

“Descending the Wall of Hope”

I enjoyed this article:

Looking back [at the Depression], it’s easy to think, “But, that was 1929 to 1932; everyone should’ve known where the market was headed.” Prechter writes:
“Emotionally removed historians sometimes decry the lack of prescience among a population prior to a long-ago financial crisis. Yet unless one is there it is hard to imagine the social pressure to go along with the trend of the day.”

Add to this, the fact that, “Most people get virtually all of their ideas about financial markets from other people, through newspapers, television, tipsters and analysts, without checking a thing,” and we have a recipe for disaster.

In the last 3 months, we have all witnessed some rather questionable investment advice. Yet, because of creeping normalcy and landscape amnesia...we do not always recognize unsound (or sound) advice. So, let’s look at a scenario together and see if the advice given by a nationally syndicated columnist measures up.

A 70 year-old gentleman is looking for a way to access more money to loosen up his budget so he can travel. He questions the “expert” on the use of a reverse mortgage as a way to access the desired money. The gentleman has $200,000 in financial assets and receives $26,000 a year from Social Security, retirement, and interest.

The expert suggests that rather than a reverse mortgage, the gentleman consider taking out a home equity loan for $25,000. This would allow for $5,000 a year in extra spending, allowing him to travel, and though (at 7 percent) the loan would accrue an additional $5,250 in interest payments, if he assumes his house will go up in value 2 percent a year, he could pay off the principal and his interest when he sells his home in 5 years.

Now, what’s wrong with this line of reasoning? We see two main issues. One is a substantial change, over the last few generations, in the way our society views debt. The other is our human tendency to extrapolate “conservative” long-term returns, rather than realizing that markets (and economies, and a great many other things) move in cycles and searching for data that would signal a transition.

Today, it seems that debt is always the solution. Politicians, central banks, and businesses have certainly set the example, but the problem is more likely our own human nature. The problem with the advice given, and the gentleman receiving it, is that neither party wants to accept limitations. And, in our current cultural mindset, that makes sense. Swept along by the current debt mania, the expert doesn’t realize the irrationality of his advice, and the gentleman, it seems, has not properly assessed his risk to achieve a less-than-necessary goal.

Additionally, regarding future returns, homes, like any other asset, offer no guarantees. Like stocks they can become historically overvalued and then decline quite sharply in value. Consider the following comments regarding the housing market and how this data could warn this 70 year-old gentleman’s that what looks like a walk in the park might turn out to be wandering into quicksand.

...in speaking of Florida real estate speculation, Dr. John Kenneth Galbraith states:

“The first manifestation of the euphoric mood of the 1920s was seen not on Wall Street but in Florida – the great Florida real estate boom of the middle of that decade. Each wave of purchases then stimulated the next. As speculation got fully under way, prices could be expected to double in a matter of weeks. Who need worry about a debt that would so quickly be extinguished?

In 1926 came the inevitable collapse. The supply of new buyers needed to sustain the upward thrust dried up; there was a futile rush to get out. In 1925, bank clearings in Miami were $1,066,528,000; in 1928, they were down to $143,364,000.”

If consumer spending comprises more than two-thirds of our GDP, and this run-up in house prices has sustained consumption, what will happen to our economy and markets when the housing bubble bursts? Will we finally achieve the ever-elusive “soft landing?”

Investors who do little research will find many reasons to rationalize their investment decisions. However, other investors, who are willing to look at information like the data from the IMF or the Center for Economic and Policy Research, will likely conclude that they shouldn’t expect a market rally, that is dependent on real estate appreciation and consumer spending from ever-expanding consumer debts, to continue.

In many ways, we’ve been here before, and it wasn’t even that long ago. As 2000 to 2002 unfolded, investor’s clung to the stocks-for-the-long-term, buy-and-hold mantra. Lacking knowledge of other options, there was little else they could do. Ignoring the cognitive dissonance, we dismissed all of our nagging concerns and followed the crowd. Yet... this period was not a time when we were climbing the wall of worry, but rather (borrowing a phrase from Jim Dines) a time when we were “descending the wall of hope.”

8 Comments:

Blogger Roro-says said...

What makes me angry about this whole thing is "I" --- a person that is NOT an economist --- saw the signs (the similarity of the current situation and the Great Depression)two years ago.

Over four years ago, the answer to EVERYTHING . . . I mean everything financial was "go into debt", it will be okay later. And I thought, was everyone asleep or absent when we learned about the Great Depression? That was the exact message EVERYONE was getting during that time. Borrow to invest, borrow to buy, borrow it's easy, it's better to borrow than to save, it's STUPID to save . . .

Now when several people told me it was STUPID to "SAVE", I knew it was time to start shaking in our boots and find out who and how the few "smart" people survived the great depression in-tact.

I would LOVE to know information about the ones that effectively survived the Depression. I have yet to find information on this.

Aug 17, 2006, 2:34:00 PM  
Blogger hemorrhoidforhousing said...

off topic but I tried to send an e-mail link to another bay area bubble blog and it was kicked back as a bad e-mail address.

The blog is at http://bayarearealestatebubble.blogspot.com/

Check it out, it has some really good stuff!

Aug 17, 2006, 3:11:00 PM  
Blogger Tako John said...

I would LOVE to know information about the ones that effectively survived the Depression. I have yet to find information on this.

No one really knows, but there are about 10,000 companies on the web willing to sell you their secrets!

In our era of credit and ongoing deficits I'm not sure we'll repeat the systematic and massive economic shutdown of the Depression, rather those people/organizations/nations with excessive debt will suffer economic stagnation and isolated insolvencies.

Those who own stock, bonds, or businesses that depend on reckless spending and deadbeat customers will get hammered. When credit tightens there's no way to buy "wants" rather than needs. I think houses (duh), autos, costly middle class travel, and costly middle class entertainment will get squished.

At some point, however, be a great time to buy stock in said industries. (With proper diversification.)

On a personal level save cash, minimize debt, maintain solid credit, and be prepared to buy assests (real estate, collectables) when others are desperate to sell them.

Aug 17, 2006, 6:36:00 PM  
Blogger John Doe said...

Hey Marinite:

Great post.


Roro-says:

The key phrase to remember is deflation. I used to be a stagflationist, but I'm solidly now in the deflation camp. Mike Shedlock converted me to his sick (albeit correct in my opinion) deflationist theories. Much like Japan suffered widespread (not debilitating) deflation and lowered rates to zero, I think this is in our future...
don't worry though, housing is toast for a while, and it won't be resurrected anytime soon. It might just return to being a use asset and people will derive value from it as a place to live, not a consumption-enhancing vehicle.

John Doe.

PS. Marinite, I researched a number of houses in your area like the piece I did for Laguna, but couldn't find a suitable match of absurdity... Marin seems to just be a lot more expensive, even in history. In South OC, nothing was expensive (relative to now) until about 2004

Aug 18, 2006, 8:58:00 AM  
Blogger Marinite said...

On a personal level save cash, minimize debt, maintain solid credit, and be prepared to buy assests (real estate, collectables) when others are desperate to sell them.

Sage advice IMHO.

Aug 18, 2006, 9:39:00 AM  
Blogger Nozferatu said...

Roro:

It's easy to make people do whatever you want them to do when you instill enormous amounts of fear in them.

For the last 5 years people have been pounded into submission from this governnment via fear of imminent danger.

Housing is probably the only warm and fuzzy thing people have had...and oh what a great time to take advantage of people from it.

Aug 18, 2006, 10:04:00 AM  
Anonymous Anonymous said...

People have also been pounded with the fear that if you don't buy now, you'll be priced out forever.

Aug 18, 2006, 12:32:00 PM  
Anonymous seamus said...

Now, what’s wrong with this line of reasoning? We see two main issues. One is a substantial change, over the last few generations, in the way our society views debt. The other is our human tendency to extrapolate "conservative" long-term returns, rather than realizing that markets (and economies, and a great many other things) move in cycles and searching for data that would signal a transition.

Hear hear. (1) Indeed, the perception of debt has changed. In some sense, this is good, and in another sense it is bad. The fact of the matter is that the world economy runs on debt -- I borrow money to build a plant or a business (or a house) which will return more than the interest on the invested debt. This is normal. Unfortunately, in the hands of many consumers it's more likely to manifest itself as a means to consumption, not investment.

(2) My employer has decided to distribute to everyone David Bach's "The Automatic Millionaire." The book is full of reasonable advice -- retire your credit cards, save, put money in your 401k sooner rather than later, etc. But it also recommends you buy a house NOW. (Bach in fact recently wrote a sequel called "The Millionaire Homeowner.") The section on why you should buy a house NOW makes sense, except that it relies on the type of assumption you described -- that a house will go up consistently every year, so your small investment will show a huge return when compared with your equity. It also assumes that owning a home costs about the same as renting on a month-by-month basis, so you can always just buy another house and rent it.

Bach also mentions and dismisses the "bubble" of the early '90s as evidence that it's never a bad time to buy. That "bubble" is looking more and more like a blip.

The anti-bubble people buy into the bubble mentality of "it's different this time." Yes, it is different this time, but not in the way they expect.

Aug 19, 2006, 11:13:00 AM  

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