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Real Estate and Asset Deflation: You Assume, You Lose

Housing-Market / Deflation May 29, 2007 - 05:14 PM GMT

By: Steve_Moyer


"Begin challenging your own assumptions. Your assumptions are your windows to the world. Scrub them off every once in a while or the light won't come in." ~ Alan Alda

Just to prove that every village has its idiots, an article in the San Francisco Chronicle's Sunday Real Estate section last week featured an assortment of irresponsible "mortgage consultants" and "financial strategists" speaking enthusiastically about the idea of borrowing against the equity in your home in order to invest in the stock market (or wherever else you might want to take a chance on achieving an investment return higher than the interest rate you would pay on a home loan).

It was the real estate section's cover story.

On May 20, 2007.

I've always had a sneaking suspicion that mindless hacks all hang out at the same art galleries and coffeehouses but this article was the one that finally confirmed it for me. Mark my words: The writer, her story's "experts" (the paper's term, not mine), the Chronicle's real estate editor and its publisher will all have blood on their hands a few short years from now.

Here we are trying to prepare people to be prudent in the face of an unfolding, devastating real estate and asset deflation and a freelance writer who knows nothing about investments, real estate or history is lining up post-lobotomy types to offer horrendous advice to people who have exercised the good judgment to live within their means while building up equity in their homes.

Meanwhile, foreclosures are rampant, scores of lenders have gone bankrupt, major homebuilders are walking away from hundreds of millions of dollars' worth of commitments, home values and sales are tanking in markets one by one all across America, banks are eliminating easy-money loan programs and the stock market sits at about 99% risk/ 1% reward on the Federal Reserve's post-bubble money-pumpometer right now.

What better time to assume the value of your home will rise forever and to risk your slowly-declining equity by investing in what might be the most dislocated, precarious and toughest-to-call investment environment in modern financial history? What better time to roll your important dice on the utterly incorrect premise that "stocks (and housing prices) always go up in the long run?"

Be sure to watch for the Chronicle's next real estate section cover story: "Why Homeowners Should Extract Another $100,000 of Home Equity and Put It All on Roulette Black."

Pity the poor soul who makes important decisions based on broad assumptions and risks his or her financial future on such reckless propositions. Fortunately, I think most people -- especially the ones who have navigated their way to having substantial equity in their homes -- are a lot smarter than these "experts," and their gut will tell them that now is the world's worst time to play Three Card Montie with one's net worth.

Articles like this one always seem to find their way into print when it's entirely too late on the investment curve, and the poor sap who takes such misguided advice to heart becomes the one left holding the biggest bag when the masses jump in ever-greater numbers off the post-bubble -- and in this case -- post-double-bubble bandwagon.

The Chronicle article's raging fools -- or "experts" just like them -- were also telling folks to mortgage their homes in January of 2000 in order to "fully capitalize" on the booming stock market. People who did so (or who bought at the time on margin) were operating on the assumption that stocks would rise forever (remember "Dow 36,000?"). Two and a half years later, the NASDAQ found itself down almost 80% and those who leveraged in at the end were ruined. (For those who haven't noticed, the NASDAQ remains down roughly 50% from its 2000 bubble peak).

Friends, if we cannot learn from history -- and the most recent, sobering portion of that "history" took place just 7 short years ago -- exactly how doomed do you think the unsuspecting are to repeat it?

We have received hundreds of emails from prudent readers across the country and around the world who have taken steps to protect what they are fortunate enough to have. I am extremely proud of our readers -- the ones who have taken the time to write in, as well as others who simply remain open to alternative points of view. Those open-minded folks who put prudence ahead of false assumptions will be the ones who survive the real estate-deflationary environment we find ourselves in today. Not only that, those able to make reasoned decisions about their investments and real estate now will be in a position to turn their near-term conservatism into once-in-a-lifetime profit opportunities when the time is right.

The time is certainly not right now.

The misguided Chronicle article got me thinking about various assumptions people might be making when considering current investment strategies. Assumptions are everywhere, and in my opinion, they rear their frightful heads for two main reasons.

One, the American mainstream financial media are essentially a marketing arm of Corporate America and they work relentlessly and from all quarters to convey their message that "all is well." They have products and services and air time and stocks and loans and houses to sell and they will not sell them if you don't feel optimistic enough to run up your credit cards and borrow against the equity in your home. Corporate America does not want you to be prudent; they want to you borrow more, buy more, spend more, charge more, invest more, refi, consolidate, then borrow, buy, spend and charge some more. Ask yourself: When was the last time you saw any of the talking heads or corporate pimps on CNBC (I mean General Electric) tell you that it might be a good idea to curtail your consumer spending and set aside money (savings, not stocks) for a rainy day?

The other main reason folks make assumptions is that they've never fully experienced the downside of an investment mania; their long-term perspective mostly includes just the upward portion of the curve. The last time stocks, bonds, real estate and precious metals all tanked together in a post-bubble credit contraction/liquidity crisis in America was during The Great Depression (for the most part from 1929-1933). That means that people who understand that all asset values can fall precipitously together when investment manias collapse and credit contracts are at least 95 years old by now. Everyone else comes to believe simply that "values go up in the long run," that the government and policymakers can pull levers to protect everyone's investments, and that it's therefore not at all risky to borrow in order to spend and invest.

Therefore, as the onset of asset deflation readies to shift into second gear, I thought it might be worthwhile to pose a few assumptions many of us might make and counter them with a different point of view. Of course I believe the alternatives I'll pose for discussion are correct and I accept the fact that you may not agree with all of them. I don't mind. All I ask is that you step away from the mainstream for a minute and take time to think about my unprostituted point of view. Stay objective. Look critically at everything and with your eyes wide open. Doing so just might keep you from walking blindly into one of the coming investment wildfires.

Assumption #1: Stock values always go up in the long run (with occasional dips along the way).

Alternative: History suggests otherwise. When investment manias happen (we've just had two in succession -- first NASDAQ, then real estate/credit -- piggybacked one on top of the other), deflationary depressions occur on the back end. Manias involve too much speculation, too much borrowed money and too many financial dislocations and as all that credit contracts, liquidity disappears and asset values decline. The S&P 500 could fall to 350 and even lower as asset deflation takes complete hold, and scores of publicly-traded companies will go bankrupt in the coming deflationary depression.

Assumption #2: Stocks got hit hard from 2000-2002 but the (30 issue) Dow Industrials have recovered and reached a new all-time high. The market has rebounded and this proves the theory that you should always buy and hold stocks.

Alternative: Much more tellingly, the (3200 issue) NASDAQ index remains down a whopping 50% from its bubble peak (it's much worse when measured in real money terms). That difference constitutes a massive, bearish non-confirmation which means that 2002-2007 has been nothing but a bear market rally. Considering the massive amount of liquidity pumped into the system via reckless Fed policy (and attendant devaluation of the dollar), the NASDAQ's rebound has been a bust and stock investors should be on greater alert as the economy begins to falter. It is likely the stock market is entering the most devastating part of its post-bubble NASDAQ decline.

Assumption #3: Real estate values always go up (with pauses along the way). Even though the stock market fell hard from 2000-2002, real estate values have continued to go up.

Alternative: Virtually the only reason real estate values bubbled up from 2002-2006 was because the Fed drastically lowered interest rates and pumped the money supply to an irresponsible degree in order to offset the effects of the NASDAQ crash. Intoxicated by 40-year-low interest rates, easy financing and substantially lower monthly payments, people rationalized their real estate purchases and what they were willing to borrow. Now, as sales have slowed by up to 40% in many markets, foreclosures and contract cancellations have become rampant, lenders are pulling in their horns and values have begun their decline, we have already crossed the threshold into real estate/credit bubble deflation. I expect the average value of real estate to drop at least 70% from peak values in the coming decade.

Assumption #4: We've seen the government and National Association of Realtors' statistics; in many areas, median real estate prices have barely dropped at all (in some cases just a fraction of a percent). It's not as bad as everyone says it is.

Alternative: Trust me, lenders and builders wouldn't be going bankrupt or watching their earnings decline 50-80% if prices were down 0.6%. The fact is, those statistics mean nothing; the reality is far worse.

Consider the word "median." You stats guys know that median means half the sales are higher and half the sales are lower in a given statistical sample. Unfortunately, the subprime, zero-down and less-qualified (less expensive) end of the market is the one that has become quickly guillotined by the changing rules of the lending game.

So, all other things being equal, if you are comparing 100 sales from a year ago with a comparable sampling this year and you "lose" 25 of the lowest 50 because new buyers are no longer able to procure easy financing, apples to apples the median price now moves up the ladder from the "50th highest" sale last year to the "37th highest" now (to say nothing of that 25% sales drop, of course). Statistically, the median price may hold on the face of that shift, but significant value erosion has already taken place. When you see markets where sales have fallen 30 to 40% but the median has held or even increased slightly, understand that values there have likely already dropped 20% or more.

Assumption #5: The dollar's drop will continue unabated; a dollar crisis is imminent.

Alternative: Everyone seems to be in agreement that the dollar is headed down, down, down, and when everyone agrees on something, it is usually time to double-down on the other side. The dollar's collapse may well be inevitable, but for now it is oversold and poised to rally for an extended period of time. While you may be on the right side of the long-term trend, you must allow for countertrends along the way and that's where we are right now. That -- and the fact that the Fed as its primary legal responsibility will work to protect the dollar's store of value -- means that we may even see higher interest rates in the face of a faltering U.S. economy. It may be several years before the dollar faces its greatest crisis.

Assumption #6: The precious metals are merely consolidating and about to head for the sky.

Alternative: Over the next several years, gold and silver will continue to decline in value as the credit contraction becomes more pronounced and lack of liquidity and savings forces people to sell assets under less-than-ideal conditions. You will likely be able to buy gold and silver at values significantly lower than they are today. My plan is to wait for a significantly bigger silver drop (from already slumping levels) and to start buying gold when it drops below $500 an ounce on its way to ever-lower levels as the liquidity crisis takes full hold. Once all the bubbles deflate, then-bargain gold will become the asset class of the decade.

Assumption #7: If we experience hyperinflation, gold will skyrocket and if the U.S. economy collapses, gold will skyrocket.

Alternative: Metals bugs are a unique breed. Their stance pretty much goes like this: Gold is going straight up no matter what and it only drops in value when central banks and guys in dark trenchcoats, hell-bent on keeping its value down, conspire to manipulate its price. Don't you think the "metals can only go up, up, up" thing sounds just a little too good to be true?

As real estate deflation begins to drag down the U.S. economy, the hyperinflation theory is already Dead on Arrival. That leaves you betting your precious metals stake on its ability to withstand the deflationary forces taking hold more and more each day. Since all asset classes have moved up together during the money-pumping phase of the Fed's reflation attempt, those same classes may well decline together as the asset and credit bubbles deflate. I expect it. Whatever you do, don't leverage into metals right now. Holding bullion is a fine hedge against something unforeseen, but the more you leverage the metals, the more you could get hurt.

Assumption #8: Inflation is the concern right now. The Fed talks about containing it, and prices at the gas pump just keep going up. The rising price of crude oil and other commodities means companies will have to raise prices to keep pace.

Alternative: Pockets of inflation do exist, but over time they will only slow down the economy even more and exacerbate the asset-deflationary trend. No-savings, borrowed out consumers continue to demand lower prices and/or "no payments, no interest" financing. Homeowners are increasingly hesitant to borrow more to spend more. Homebuilders, automakers, retailers and other companies are finding a general lack of pricing power and squeezed profits (or losses). Many commodities, including crude oil, gold and silver have long-since topped and falling real estate values, a shortage of U.S. savings and the burden of too much debt will only intensify the trend. One by one, remaining, overly-speculated investment classes will be taking their hits as the trend intensifies. Real estate deflation and its credit contraction are forces simply too great to overcome.

Just knowing that these possible outcomes exist should be enough to keep you out of harm's way. If articles like this one prompt you to hold your cards a little closer to the vest, my guess is that you'll be a winner in the long run.

The Fed's reflation policy has allowed most of us to make a remarkable run at the craps table. But there are times in your financial life when you let it ride; other times when you don't. The great gamblers are the ones who know exactly when to take their big stack of chips off the table and go home.

They're the ones who end up owning the casino.

By Steve Moyer

Copyright © 2005-2007 Steve Moyer
He has been an investment real estate broker since 1982. He is a columnist and the assistant editor of the monthly newsletter, Ponder This .... .

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