Crushed

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Dustin’s a doubter. He wrote me yesterday from a prairie somewhere. “I’ve been following you for some time now, along with other “contrarian” personalities,” he says.  “I think we all know that with rising interest rates that assets such as housing will obviously go down. But is your strategy of investing in the stock market during the time of rising interest rates a sound one?

“How about preferred bank shares? I’m going to say that these banks will suffer when housing prices decline and people are unable to renew mortgages, walk away etc.  In general though, the stock market as a whole would essentially suffer.  An echo of the American financial crisis per se, although not as grand in scale.  My take on this is that housing will not be the only dog in this “show” and that other assets will not be immune to the punchbowl being taken away.”

Well, Dustin is right about one thing. Rates will rise. The Fed made that clear yesterday, and we’re still on track for the first hike in years to take place in September. As I said yesterday, our poodles will eventually follow suit. There will be no more 2.6% five-year mortgages this autumn.

As rates rise, real estate cools. How much sales and prices are affected will vary by market and other factors we don’t yet know. But the long-term direction is obvious. Just take a look at the latest StatsCan numbers hatched  Wednesday – Canadians have been on a borrowing binge for the last ten years with indebtedness growing by 64%. By 2012, 71% of us were in hock – no surprise, since almost the same percentage own houses.

So, family debt and real estate values have been moving in lockstep – about what you’d expect. That means stability, even if incomes don’t swell at the same pace, so long as interest rates stay in the ditch. Hard to overstate the importance of cheap money, because once rates creep higher, house values (and net worth) inch lower, but debt levels remain the same. Ouch.

Now, what of Dustin’s fear that financial assets will also tank?

Could happen, of course, but history suggests otherwise. Interest rates were coursing higher between 2004 and the financial crisis of 2008. Then we suffered the worst market decline in 80 years including a global credit crisis, followed by six years of emergency rates and one of the slowest recoveries in modern history, complete with a US debt ceiling scare in 2011.

Despite all that, a portfolio that’s balanced (40% fixed income and 60% growth assets, no individual stocks, no mutual funds) and diversified (across asset classes and geography) averaged 7.41% over the last decade. The five-year number is 10.06%. Last year it was 8.5%. So far this year (four months) it’s returned 4.2%.

In other words, the performance has been remarkably consistent through one of the most volatile and unprecedented decades in the lives of everyone reading this pathetic blog. When rates rose, it did fine. When they fell, it was cool. When crisis hit, it recovered fast. Overall returns have paced or exceeded almost every real estate market. And unlike houses, such a portfolio paid regular income, didn’t need reshingling, avoided property taxes and needed no bozo in a Audi charging 5% commission to sell it.

But what of now? Are things so much worse that little Dustin could be creamed if he invests?

Of course not. There’s so much more risk in buying a bungalow in the GTA with 7% down than there is investing in a rational portfolio. Rising interest rates actually mean economic growth – because central bankers (like the Fed) wouldn’t even consider getting back to normal if they thought the economy might croak. More growth means more corporate profits, more jobs, and more growth. Nothing scary there, unless you have an epic mortgage.

As for preferred shares, they slid about 10% this year as the Bank of Canada foolishly trimmed its key rate, and that is expected to reverse. In fact, rate reset preferreds (now the majority of the market) will bob higher along with the cost of money. (Yes, that means they’re now on sale.)

Banks in trouble? That’s rich. There will be no mass defaults on Canadian mortgages, and no streets-full of people walking away from their indebted homes. Even so, bankers are insured and are now enjoying record profits, even in a soggy economy. But if bank profits were to dip, preferreds would surely retain their value and continue to churn out tax-reduced dividends.

So, higher rates mean an economy’s thriving, just as low rates mean decline. When money costs more, people borrow less, or accelerate debt repayment. How’s that worse than the borrowing binge we’ve been on?

Things are getting better, Dustin, not worse. And if a decent portfolio can deliver 7% over the decade we’ve just had, why would you suddenly expect losses?

True, many homeowners with scant equity will be crushed. The moaning and gnashing will be deafening. But there’ll be no tag day for the balanced. Still time, kid.

Go away

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Well, it’s prediction time here on Greater Fool. But because forecasting is hard when it involves the future, this blog’s loaded up on E & O insurance, which was conveniently added onto the Harley’s coverage. So we’re good.  Full collision.

Canadian rates will be higher by Thanksgiving.

Every indication from the Bank of Canada, including testimony before Parliament on Tuesday, is that central bankers think they overreacted in January. Of course they won’t admit it. But it’s out there. All that winter rate cut did was pour gas on the real estate fires in the GTA and YVR, increase consumer debt and borrow from the future.

Now banker boss Stephen Poloz is taking every chance he can get – like in New York last week and Ottawa this week – to claim the same thing: the oil crisis was front-end loaded into the first few months of 2015, and it all gets better from here. Economic growth will improve, along with the labour market, consumer spending and exports – he says.

So what? So no more rate cuts. It’s over. In fact, after the US Fed raises its benchmark level in a few months, our central bank will follow suit, restoring January’s decrease and embarking on a slow path to higher money costs. No, rates won’t spike. Yes, you have time to lock in. Six months. Govern yourself accordingly.

There is no real estate relief coming.

If you thought CMHC might tighten the rules again, that big lenders would be spanked for teaser mortgage rates or the feds would move to corral our burgeoning subprime mortgage business or the bank of Mom, forget it. We’re on our own. That means $1.1 million detached houses in 416 and 12-foot-wide houses in Van selling for $1.35 million are here for a while, until the days of reckoning.

Joe Owe did not even mention runaway property prices in the budget last week, and this week Poloz went further. “It would be very unusual to come through all of that and not have a degree of overvaluation,” he told MPs, referring to the sweet mess that emergency interest rates have made of housing affordability. So despite its own report saying real estate could be too expensive by 30%, the bank is retreating. Meanwhile Poloz’s deputy governor insists we’re headed for that “soft landing.”

What does this mean?

Just what I said above. They know mortgage rates have bottomed this spring, that the cost of money has only one direction in which to go, and the effect on real estate values will be palpable. They just can’t say it. At least not until October 20th.

Oil’s messing with your head. Lower prices soon.

While the price of crude has risen about 20% in the past month, moderating despair in the Calgary real estate market and raising hope it was all a big, temporary joke, don’t get too excited. Oil at $57 or so won’t last. There are a bunch of valid reasons for this. For example, the OPECers have not stopped pumping and continue to flood the market with black stuff. Second, oil storage facilities in the US are brimming. There hasn’t been this much of the stuff for at least 80 years. Third, there are literally thousands of wells drilled in major US fracking areas, ready to produce but  temporarily capped. American production of the stuff has doubled in the past five years, and is ready to explode again.

Don’t believe me? Check futures prices. Traders are actually forcing prices lower. The bet now is for $60 oil in 2019. Yup, if you’re waiting for happy days again before selling that Cowtown McMansion, good luck. BTW, the dollar’s going to be whacked again, too.

Here’s what this tells us: whether you believe it or not, mortgage rates are as low as they’ll ever be. Conversely, real estate values – at least in the hot zones – are likely at their zenith. And the economy will stay stalled. It’s hard to imagine a worse time to buy. Three reasons for that:

(a) Rates can only go higher.
(b) Prices will only go lower
(c) Competition is extreme, because
(d) Nobody believes (a) or (b).

When it comes to houses, heed to best advice stock traders ever heard. Sell in May, and go away.

Postscript:

Yesterday I told you how blog dog Mike reacted when he saw Tarek & Christina’s flip-in-Van-for-profit seminars advertised on Facebook. Today he was banned by T&C for his post below. “Thanks for posting my screen shot. I’ve been banned from posting on their Facebook after my comment: (I don’t blame them, I guess! First rule of scamming stupid: keep the smart people away!)”

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