The correction

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When a study came out the other day saying Canadians are among the ten richest peoples in the world, it wrecked the romantic moment by adding this:

“Although financial assets made a relatively speedy recovery in the aftermath of the crisis, achieving annual growth averaging 8.1 per cent per annum over the past five years, the financial situation of Canadian households is anything but sustainable. Macroeconomic shocks like rising interest rates, a labour market slump or falling house prices could pose a serious threat to the solvency of highly-indebted households.”

But what if they all happened at the same time?

It was a question worth asking on Thursday as stock markets took a dump, along with commodity values, the dollar and business confidence. Even the banks were whacked, with CIBC shares falling enough, for example, to wipe out most of a full year’s dividend payments.

Why did markets plop?

Lots of immediate reasons. Apple was punished after people found their new iPhones bend when they sit on them (imagine!) and the system upgrade has bugs. Cheesy Russian politicians are working on a bill to seize foreign assets, like McD stores in Moscow. The ISIS numbnuts may be planning to blow up the NY subway system. Ebola is out of control. Syria’s burning. China’s growth is slowing.

But mostly investors are worried the US economy is growing too robustly, which means the Fed will start raising interest rates sooner than anticipated in 2015. After all, the GDP is romping ahead by 4%, stimulus spending ends next month, the federal deficit is falling and corporate profits have been consistently strong. Yeah, lots of people are on food stamps, unemployed and pissed, but the fact is the investor class has been doing great. The S&P gained almost 19% in the past year, even after the Thursday give-back.

So when enough little shocks hit, with financial asset values sitting at record levels, smart people rebalance. They take money off the table, harvest their gains and invest in under-performing assets. Really smart investors wait for days like this, hope there are more, and buy stuff when it’s cheap. It’s the opposite of what happens with real estate, as buyers disappear when prices decline.

Speaking of which, this might be of interest. Below are the 12-month gains for the TSX, the Dow, and the S&P 500, as well as house prices in Calgary, Toronto and Vancouver, in percentage terms. You can see that only the Cowtown market comes close to approximating returns on equities, but remember that in order to realize this ‘profit’ on a house you have to sell and pay tens of thousands in commission. That would suggest the average digs in Vancouver, for example, returned nothing on all that money invested in it. Bummer.

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Well, here’s the point the Euro report was making about net worth gains in Canada. They’re very fragile, since we’ve all put so much into a single asset. Increases in personal wealth have been supported by giant dollops of new debt, not higher incomes. In fact, the job market in Canada sucks, as evidenced by a 14% youth unemployment rate and the loss of 110,000 private sector paycheques last month. In contrast, the US has churned out 1.2 million jobs this year and – believe investors – is ready to fluff rates.

The contrast between the US and Canada is growing stark. Look at the dollar – struggling to stay above 90 cents. Thus, it seems quite possible that 2015 (a hundred days off) will bring higher mortgages, scant new jobs and fewer reasons to spend $700,000 on house you can’t quite live in.

Could be a perfect storm for your brother-in-law and his three ‘investment’ condos. Or your house.

Happily, though, stocks are on sale.

A valuable lesson

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In late 2007 I figured we were on the wrong path. The government had just introduced 40-year mortgages and 0% down payments. As an MP and member of the House of Commons Finance Committee, I tried to stop that. I failed. Conservative members pushed it through.

I then wrote a book, “Greater Fool” about how the US real estate meltdown, at that time just gathering speed, had the potential to come to Canada. My publisher hosted a stirring little reception on Parliament Hill to launch it. Lots of MPs came, got their free copy, look bemused, had several glasses of wine and split. With the book.

DDM The next day a Conservative MP rose in the House to mock the book, and me, as “Parliament’s greatest fool.” That was Dean del Mastro, who served as the prime minister’s Parliamentary Secretary. He’s on trial right now for electioneering fraud, and I hear it’s not going well.

Then the financial crisis washed over us. Housing markets plunged. The central bank brought in emergency interest rates and real estate revived. You know the rest. After five years of artificially cheap money, Canadians have decided there is only one asset they can trust – their homes, regardless of the cost.

We now have more public and private debt than anyone could imagine when I wrote that book. The home ownership level has risen. The average single-family home in two major cities now costs more than $1 million. Real estate became a cult, then a mania and finally a religion. As a result, risk has elevated exponentially.

You know why. Incomes are stagnant. Job creation is uneven and sparse. Half of us couldn’t survive one missed paycheque and the Millennials can’t climb out of basements. Now real estate accounts for more of the economy than oil and gas and manufacturing combined. And at the same time, half the housing markets in Canada are in some kind of distress.

Yesterday I received this email from a guy in Burnaby – supposedly one of the hot spots.

“We put our home up for sale a month and a half ago. So far we have no bites and priced it at the lowest proposed value by the agent to be competitive. Outlook is bleak. We are going to take a hit on it (it’s been languishing on the market and the agent suggests a reduction as no offer is on the horizon). I’m fine with the hit so I can rid myself of this mortgage and unit I stand to lose 60-90k in this valuable lesson. Our agent has marketed this puppy ceremoniously and the greater fools are just not making offers.”

How can this happen when five-year mortgages are available for 2.9%, when down payments are tiny or non-existent, when bankers dole out loans to anyone who doesn’t drool, when you can raid your RRSP to buy and everybody you know says real estate’s for sure?

Because it will end. It always does. All booms finish badly.

So this pathetic little blog has spent the past six years suggesting you get ready. That explains the constant, tedious, boring, repetitive, deadening, irritating endless repetition of lessons on diversifying out of real estate to mitigate risk. How to build a balanced, diversified financial portfolio. What to do with TFSAs, income-splitting, RRSPs and tax avoidance. And if you do buy a property, ways to protect yourself, read past the misleading data, write the best offer plus escape the clutch of the unethical realtor. I think enough people took heed to make all the crap I’ve endured worth it. At least old Dean’s not dissing me anymore.

All of this came to mind as I read about a new guy with a new book. Hilliard MacBeth is from Edmonton and will soon publish “When the Bubble Bursts: survive the Canadian real estate crash.” He says this will happen in the spring, and your house could lose 50% of its value. His core advice is to sell now and rent.

I’m happy the house-humpers, sleazy real estate marketers and whackos on this site will have someone else to vilify. But nobody should get too excited about houses losing half their value, since it won’t happen. (The US melted when houses lost 32%.) If it did, with 25% of the GDP at stake, you’d have more consequential things to worry about – like 1930s-style unemployment and where to find a squirrel gun. Far more likely is what the Burnaby dude is experiencing – illiquidity and equity evaporation. This is a killer of personal wealth, without being a slayer of the economy.

Worse, it’s probably too late to avoid. Outside of 416, 604 and the oily parts of Cowtown, these are already realities that even dirt-cheap home loans cannot prevent. Over time the holdout markets will be impacted. Those who have leveraged the most will find themselves underwater and facing some tough, ugly choices. Those who will fare best are the ones in urban detached houses they view as homes, not investments, and who’ve diversified into plump, balanced portfolios.

Will that include you?