“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.”