French Toast

The title of this brief post does not refer to the disgustingly sugary culinary monstrosity of the same name, but rather to both the precarious state of the French economy/banking system/government and the trade idea that we’re going to illustrate here, the recipe of which also includes an important German ingredient.

This is in our opinion an excellent trade, not only because it has the potential to deliver significant gains, but more importantly because of the exceedingly tiny amount of risk that it entails: it is a lesson in asymmetrical investing.

So without further ado here is this brilliant idea: sell short an amount X of French OATs against an equivalent amount of German Bunds (i.e. buy 100€ of Bunds for every 100€ of OATs sold). This basically removes interest-rate risk from the equation (so that we don’t have to correctly forecast whether rates are going to rise or fall) and leaves only country-specific risk on the table, the idea being to sell the higher risk bond against the lower risk one, in the expectation of a re-pricing of the two that better reflects the real risk differential, currently suppressed by the various alphabet-soup policies of the ECB (such as LTRO and OMT) as well as the supportive buying of overleveraged French banks.

What’s so interesting about this trade? At the time of writing, the spread between the yields of the two bonds is a paltry 53bps (that is: the French 10yr bond yields 0.53% more than the equivalent German security).

Now we don’t know about you, dear readers, but we regard the possibility of French Bonds yielding less than German ones as quite remote, to put it mildly. Even yield parity seems to us to be extremely unlikely. Yet, let’s consider this as our worst-case scenario: all that it entails is a risk of 53bps, practically nothing (in our own risk analysis, we objectively consider the likelihood of the spread going as low as 25bps). On the other hand towards the end of 2011, during the height of the European crisis, the spread reached a high slightly above 200bps: is that feat repeatable? Of course it is! We would actually wager that it’s likely to be exceeded, for the reasons we’re going to enumerate in the next section. So, the extremely pessimistic scenario has us losing 53bps and a moderately optimistic one has us gaining 100/150bps, all this without having to take a stance on the direction of the underlying market (interest rates): not bad it seems!

The only caveat is that since the 2011 rout ended OATs have shown the tendency to trade as a safe haven rather than as risk-on securities like BTPs and so far there is no indication that this may be about to change (although these phenomena tend to occur quite abruptly and without advance notice). As such, the prudent speculator might want to wait for definitive confirmation before committing to the position (i.e. he may decide to act only if and when OATs prices start to diverge from Bund prices, thus leaving some money on the table, but lowering his chance of failure and shortening his waiting time). Another option, that we’re also currently weighting, could be to sell a mix of OATs and BTPs, the latter offering lower risk but also a more uncertain return and the former offering exactly the opposite (i.e. a higher potential return, but also greater losses should the current calm that permeates the markets continue: the current spread stands at around 260bps and under such a scenario it could easily go to 150bps or lower).

We won’t make any specific remarks about Germany, apart from the following: the country is far from being a sanctuary of fiscal rectitude and a refuge for free-market enthusiasts. It is simply further removed from the edge of the abyss than its neighbours (a big plus is that it does not have a real estate bubble, although one is incipient).

The French Connection

1. Government Finances

As of the end of 2012, the French Government sports a 4.8% budget deficit and a 90.2% debt-to-GDP ratio. It has also forecasted a 3.7% deficit for the current year: we let our readers ponder on the likelihood of that target being reached (in our opinion chances are slim to none and slim is out of town). Now, these do not seem particularly comforting numbers, especially when one considers that a serious recession can significantly worsen the budget picture, by simultaneously lowering tax revenues and increasing expenditures. As we shall see below, there’s also the very real possibility that French banks will require a massive bailout, further increasing the public debt and actually bringing it to a completely unsustainable level. And of course the fact that the French Government is run by a bunch of twats (the wonderful definition of this word being: “a man who is a stupid incompetent fool”) who think that economic success ought to be punished doesn’t help: see “The Economy” section below. A final remark: public spending already accounts for roughly 57% of French GDP.

2. The Banks & The Housing Bubble

The French banking system’s total assets are more than 400% of French GDP, with the largest three banks, BNP Paribas, Crédit Agricole and Société Générale (mind you: there’s the guillotine ready for those foolish enough to get even a single accent mark wrong), accounting for a whopping 240%. This should drive home the point that there’s no way the French Government could possibly “save” its banks if they were to run into serious trouble (doesn’t mean it won’t try, though). French banks are also highly leveraged (this is true of most European banks, with the German ones topping the list) with assets-to-equity ratios routinely around 30/40, they have large exposure to OTC derivatives and they’re allowed to assign a 0% risk-weighting to French OATs, allowing them to buy gobs of them entirely with funny money (i.e. with pure leverage) and thus linking their fate even more to that of the state. The last point means that they could provide support to OATs prices for a while, but it also means that the whole exercise is destined to end in tears (see Greece, Spain and to a lesser extent, at least so far, Italy), as two drunks try to hold each other up.

The catalyst that may ignite a banking crisis in the country is of course the bursting of the huge real estate bubble that has now reached historical proportions (for a discussion on the French Housing Bubble, please see our recent post on the topic) and to which French banks are heavily exposed as is “de rigueur” to be, with very high Loan-to-Value ratios to boot (loans with LTV ratios of 100% or more were common at the height of the bubble). You can archive the following words, uttered by Oudea in June of 2012, under the tag “Famous last words”: “Societe Generale SA (GLE.FR) Chief Executive Frederic Oudea said Wednesday that French banks were not exposed to the type of real estate bubbles that have caused other major banking crises. Speaking on French radio, Mr Oudea, who also serves as president of the French Banking Federation, said that "major banking crises come from real estate bubbles," citing the U.S., Ireland and Spain. "The very good news for France is that... there has not been the same real estate bubble [in the country]," he said.” Very good news indeed, at least for short sellers!

3. The Economy

The French economy is suffering from a serious recession. A combination of counterproductive economic policies (that include not allowing loss-making enterprises to restructure by firing workers), stifling regulations and bureaucratic requirements, ever-rising taxes and huge malinvestments engendered by the mispricing of capital due to the ECB’s interest rate manipulations all but guarantees that France is in for the bust of a lifetime.

Let’s see some data: GDP is contracting at a quarterly pace of 0.2% and has been basically flat since late 2011; the unemployment rate stands at 10.6% and growing; PMI readings are dismal, both for the manufacturing and services sectors, and retail sales aren’t faring much better (here, here, here and here the links to the latest Markit press releases, which also provide a bit of perspective); industrial production keeps on declining at a worrisome pace and has been in contraction since the beginning of 2012; both business and consumer confidence are in the basement, with the latter now being lower than at the height of the 2008 financial crisis; car registrations are also at multi decade low (another sign of the bursting of the bubble). We could go on and on and on, but we think you get the picture!

As such, we’re not surprised to see that loan-loss provisions are starting to rise at major French banks, as businesses and households face increasing financial difficulties and as the economic crisis favours and accelerates the bursting of the RE bubble. In fact, we expect to see more and more of the above, as the crisis gathers pace and starts to impact more directly the banks’ balance sheets.

The rather depressing chart of France QoQ % GDP growth (or lack thereof), via Tradingeconomics.

France’s unemployment rate: notice the troubling trend. Courtesy of Tradingeconomics.

The tragic chart of France’s % change in industrial production, again via Tradingeconomics.

A long-term chart of business confidence: not very inspiring. Thanks to Tradingeconomics.

This chart is even more depressing: it shows consumer confidence at an new all-time low, via 

Tradingeconomics.

Conclusion

There’s no doubt in our mind that France is headed towards a meaningful crisis, that moreover appears to have already begun. The question is whether this event will engender a re-pricing of its sovereign debt or whether the bland reassurances of Super Mario will prove to be enough in preventing “contagion”. Our personal answer to this question is that we’re in for a quite wild ride in French OATs, but in any case the very low level of risk of this prospective trade makes it very appealing in our opinion, as the cost of being wrong is almost non-existent. We obviously encourage our readers to do their own research on the matter: caveat emptor!

Ladies and Gentlemen, it is with great pleasure that we hereby present you with…

…what is possibly the greatest gold contrary indicator ever! Ladies and gentlemen, please welcome to the stage Mr. Ananthan Thangavel (a round of applause follows as the excited crowd cheers him on)! Apart from titillating our fantasy as we imagine the scene (we recently rediscovered our always-present and yet long-lost love for acting and performing), the objective of this post is firstly to inform our readers about the extremely high likelihood that a final bottom has been printed in the PMs market (a bottom that warrants further additions to our already very large positions) and secondly to present them with what to our eyes appears to be an extremely effective timing tool for our purchases: the short calls of Mr. Thangavel. It is not our intention to ridicule Mr. Thangavel (at least not much) as we know that investing is far from an easy business and everybody is bound to make their shares of mistakes (and we’re certainly not immune to this phenomenon, as e.g. we weren't expecting the collapse in PMs on the back of already extreme levels of pessimism). What we want to show, however, is that doing fundamental analysis using horribly wrong premises, spurious arguments and a wide array of trite fallacies vastly increases the possibility of committing grave mistakes. We are convinced that unless one is motivated to learn what sound analysis really is, then one would be better off just trading technically, without concerning (and burdening) himself with any fundamental considerations. Take Peter Brandt as an example: he obviously can’t differentiate between valid fundamental arguments and hogwash and yet he goes on to trade profitably by using simple charting techniques, prudent risk management and a multi-decade experience (and kudos to him for having been on the short side of the PMs markets for quite a while).

A brief review of Ananthan’s latest article

We intend to start with a point-by-point rebuttal of the seizure-inducing nonsense spouted in Mr. Thangavel’s latest article (which he published on May the 7th, so at least he got a couple of weeks of glory as prices collapsed!). Readers are encouraged to read it before proceeding through our post, as we’ll only quote brief passages of it or simply articulate our positions assuming that readers are familiar with the other side of the argument.

• “we did briefly believe that the initiation of QE3 would be a positive catalyst for gold back in September 2012” : excellent, you demonstrated you know how to pick tops as well, as your long call arrived when prices where around 1760$/oz. and topping. 

• “As can be seen from the chart, gold rose in a fairly steady pattern (with 2008 being an extended correction), from the early 2000s until September 2011. Viewing this chart, it appears the perfect picture of an asset bubble and collapse.” : if you say so… To us it seems like a powerful secular bull market experiencing a cyclical bear market correction. This chart, courtesy of Macrotrends, seems to confirm our suspicion:
  
  

A chart comparing the percentage gains of the current gold bull market with those of other major bull markets: we can’t see any parabolic rise so far, in spite of what the hawk-eyed Ananthan says.

• “Considering there is no "right" price for the price of gold, but rather only the price that the next buyer is willing to pay, more and more investors came around to the bullish gold thesis, and this gradual realization drove the price higher.” : congratulations, you just discovered that prices are the composite result of a myriad subjective value judgments by economic actors. Unfortunately for you, this is an insignificant platitude that is true for all goods, not only for gold. No, there is no such thing as “intrinsic value”! Quick Austrian explanation: for a voluntary exchange to occur both parties need to value the goods to be acquired more than the goods to be exchanged for them (otherwise no transaction would take place, as both parties would expect a loss, rather than a gain, from the exchange): in short, this is called a reverse valuation. From this it logically follows that all values are subjective: if goods had an objective, intrinsic value, then there could be no reverse valuation (except through error). In other words, all exchanges would have to rely on the error of one or both parties to occur and this is obviously impossible (think about the coexistence of innumerable satisfied iPhone buyers and of large Apple profits: evidently they both gained from the transaction and no “right” price for an iPhone exists). 

• “However, by 2011, nearly every market participant knew or understood gold's appeal, and since gold could be easily purchased through an ETF or futures contract, everyone who believed in the thesis was in. The following chart shows the number of ounces of gold held by ETFs. […] We believe this massive accumulation of gold was the primary driver of the most recent leg of the bull market, punctuated by leveraged futures traders exacerbating the final spike. Moreover, ETF and futures demand for gold can be considered the marginal player, as central banks and other physical gold holders rarely trade in and out, so ETFs are setting the marginal price due to their relatively high turnover.” : here we have a powerful combo of specious arguments.
  A) It’s highly debatable whether in 2011 “nearly every market participant” had an interest in (much less an understanding of) gold’s appeal: there certainly was excessive speculative fervour and widespread bullishness, but certainly we saw no signs of a speculative mania (and at least we know that our good Ananthan had no interest in and certainly no understanding of gold). Moreover, we know that since gold does not get “used up” and a large stock of it exists (roughly equal to 50 times the annual mine supply), then it follows that all this gold has to be held by someone at all times: what matters is not whether “everyone is in” (in light of the above this sentence is meaningless), but whether at the current price there is or there isn’t an equilibrium between total stock and total demand to hold (which includes the demand to acquire gold and reservation demand to hold it) and whether the current price correctly reflects future anticipated conditions (if it doesn’t, then an adjustment is inevitable, in the form of an increase or decrease of the total demand to hold and hence an increase or decrease of the price until a new equilibrium is reached. The total stock bears little relevance as it’s almost a fixed constant). The heart of successful speculation is the ability to correctly gauge the current and the future relationships between supply and demand and identify meaningful discrepancies that could give rise to powerful trends in price (e.g. there currently is a large supply of sugar and hence prices are very low. Yet we anticipate a future situation in which this abundance disappears and hence we speculate on a meaningful price increase).
  B) The usual tripe about ETFs holdings… With 170.000 tonnes of above-ground gold what the hell does it matter whether ETFs hold 1.000, 2.000 or even 10.000 tonnes? All gold has to be held by someone, all that matters is at which price the market clears, i.e. at which price demand to hold and available stock match. Moreover, it’s evident that ETFs are tiny tiny players in the global gold market. They have no doubt made it easier for Joe Public to invest in PMs, but they’re still a minuscule source of demand. Moreover, the gold they buy is sold by someone else and that someone cares little whether the buyer on the other side is an ETF, a central bank, a large dealer or whatever: all he cares about is the price he can get (and whether that price is high enough to entice him to sell). So ETFs may be useful as a proxy for sentiment towards PMs, but their buying and selling most definitely does not influence the price. Have a look at the London Bullion Market’s size and then figure out for yourself whether GLD shedding a few hundred tons over the course of six months really matters much.

• The paragraph titled “When bubbles burst: prices cannot catch up to unrealistic expectations” is a concentrate of gibberish. First of all, bull markets do indeed generally end when the fundamental drivers no longer are in place or when they have at the very least significantly deteriorated (reference our post on the subject).
  Secondly, as we have observed above, good luck comparing gold now with the Nasdaq in 2000 or housing in 2006…
  Thirdly, mistaking a cyclical bear for the end of a secular trend is a mortal sin amongst speculators and pretending that an asset responds in the most obvious manner to news is utterly naive: if speculation were as easy as reading the paper and then doing the most obvious thing (like buying gold on leverage the day Bernanke announces his QE program), then we’d all be Soros. Moreover, all secular bulls experience cyclical corrections: in 1987 the secular stock market hadn't ended (as the secular drivers of said trend were firmly in place), BUT the then-current circumstances warranted a temporary and meaningful correction. The same goes for gold in 1975, stocks again at the beginning of the ‘90s etc. etc. etc.
  Finally, what about his assertions that “The current fundamental problem in the gold market is that every bullish fundamental has already been revealed” and that “there is no upside surprise left for gold investors, but there remains plenty of downside surprise.”? Well, save those lines for the stock market, dear Ananthan! In our opinion, it is obvious that there are still plenty of “hidden” bullish fundamentals for gold (hidden of course only for that 90+% of people who have never heard of the Austrian School) that will not fail to make themselves evident once the current monetary madness finally delivers its results. And be assured: that will be the time to sell, as the Ananthans of this world will rush to buy! Just as obviously, it seems to us that right now there are no downside surprises left for gold, given also the recent crash (a 4-standard-deviation event): the world economy is just perfectly fine and on the road to a strong recovery, no bad consequences can possibly result from massive inflation, debts will no doubt be repaid with honest money and all the perks and amenities of the welfare state will be maintained and even increased.

• The next paragraph is another questionable one. Gold secular bull trends tend to happen during periods of economic crisis, when stocks are generally locked in a secular bear. We have discussed the matter in a previous post. There may be periods of positive correlation between the two assets, but the overall secular trend is clear. Moreover, if the Fed stops printing, good luck with trying to keep the current global financial ponzi scheme from crumbling. In that scenario (a highly deflationary one) we seriously doubt gold would perform poorly. It may decline in nominal dollar price (not very likely and mainly dependent on whether the U.S. gov’t can remain solvent), but it is certainly going to increase its purchasing power (i.e. the amount of “stuff” like oil, houses, cars, stocks, food etc. that you could buy with a unit of it) exactly like it did in 2008. If, on the other hand, Benny keeps on inflating (a very likely outcome) then good luck with trying to keep the current “Goldilocks Economy” in place for much longer: either a bust of massive proportions or a prolonged period of significant price inflation and stagnant economic activity or even the Misesian crack-up boom would likely appear and all three scenarios are bullish for gold (with the last one being wildly bullish). We’ll tell you how gold could be hurt: if Obama were to be possessed by the spirit of Murray Rothbard, so that all at once he would abolish the Fed, repudiate the debt, stop spending, cut taxes and regulations and let the free market re-establish equilibrium (of course he would have to be exorcised before being able to re-establish the gold standard, otherwise the scenario would still be bullish).
  
  
• “Future for gold”: another bit of gibberish about ETFs holdings coupled with the following: “At this point in time, with interest rates around the world staying low indefinitely, investors are grabbing for yield anywhere they can find it. Nearly every other asset, between stocks, fixed-income, alternative, and real estate, produces a higher current yield than gold's 0%. Given the fact that gold has not made a new high in 19 months, traders can no longer rely on price appreciation to make up for gold's lack of yield and utility. Therefore, they are selling the metal, and they have quite a bit more to get rid of before all is said and done.” Yes, you have got this one right Ananthan, although you couldn't resist mentioning the usual nonsense about the supposed bearishness of the liquidation of miserable gold holdings ( by the way, as far as we know sellers do not just throw their gold in the ocean, but rather sell it to buyers who become the new holders). Investors are indeed selling gold to chase other assets. The important question however is: is that likely to generate good returns? Personally, we wouldn't touch a junk bond yielding less than 5% with a ten-foot pole… Ditto for a stock market sporting a CAPE10 of 25 and a Q ratio above 1, both levels at which secular bull markets have ended, not begun.
  
  
• And now hold on to your hats, dear readers, as the two last paragraphs are riddled with enough rigmarole to make us almost pass out: “Given that gold is a commodity, most commodities eventually trade to their cost of production. Those of you that have taken a basic economics class will remember that marginal cost = marginal revenue. […] If investment demand continues to decline and gold ETF holders continue to sell, we believe a gold price below $1,000/oz is a near certainty. Gold will eventually return to its true cost of production, squeezing miners' profit margins.” It seems to us, dear Ananthan, that you are the one who failed to attend a basic economics class: please show us another commodity whose available supply pretty much equals the entire cumulative production that has taken place over the course of all of human history (save for a few sunken Spanish galleons and a few other tons that got either lost or consumed). In such a situation, the price of a real commodity, like corn or oil, would no doubt plunge far below the cost of production, since such an abundant supply would mean that nobody would need to actually produce the stuff (at least for a few decades) and hence the market, via its profit and loss mechanism, would send the signal that the scarce resources employed in the production of such a good would be better employed in other lines of production (in simple words: nobody would make a frigging dime producing that commodity). So, how come that gold prices do not plunge far below its cost of production, notwithstanding the huge above-ground supply? Well, maybe after all gold is not a commodity or, more correctly, it is a commodity whose function is to act as money, no matter how emphatically Ananthan tries to explain us how gold cannot possibly be money by babbling assorted nonsense. Gold being money, reservation demand plays a fundamental role in determining its value. This demand is of course fickle and subject to continuous changes, but all that matters to the astute investor is to correctly determine the likely direction of its trend, i.e. whether it is likely to increase or decrease meaningfully over the next few years. Truth be told, he is right in saying that gold is not a commonly accepted medium of exchange, but this happens not because it does not possess the characteristics of money (i.e. not because it lacks “moneyness”) but only because of government coercion in the form of legal tender laws. Proof of this assertion can be found in the fact that when a paper money system collapses, specie money always regains its rightful role as a medium of exchange.
  
  
• And finally Ananthan dispenses a wonderful pearl of wisdom for the benefit of the hoi polloi: “The problem with gold is that the market sets the price and there is no fundamental value. We must always be cognizant of this when investing in a psychological asset.” Ah, so now we know that gold is a psychological asset, whatever that means (we’ll no doubt interrogate a friend of us who happens to be a shrink on this and we may even put a gold bar on his couch so that he can properly analyse it)! Moreover, we also learn that gold has no fundamental value and that its price is set by the market and who cares if that is true of each and every asset on this planet (see the explanation above): certainly this only matters in the case of gold!

And with that last bit we have finished our rebuttal and we can move on to next part of the post (interested readers can spend some time overlaying the dates of Ananthan’s calls to short PMs to a chart of gold and see whether they notice any patterns). But before moving on, we want to mention that we’re not singling out Mr. Thangavel, as the drivel he spouts is usually used by a great many other analysts, nor we’re attacking him because he holds different views from us: what we’re criticising here is the shabby and shallow analysis and the careless use of specious arguments that don’t hold water. If someone were to say us that he’s short gold because the chart is bearish and there has been a breakdown, then we won’t have anything to object. We would still continue to be long (as we have our own way of investing), but we won’t engage in a debate with him: successful technical traders are very worthy of respect. But if someone comes up and says that he’s shorting gold because money printing is helping the economy and other assorted BS, then we can’t avoid dissecting his arguments and showing them for what they really are: nonsense.

The current technical and sentiment picture

Right now, after a series of endless plunges and crashes that no doubt helped clear the market from all kinds of even remotely weak hands, we see that both gold and silver have put in nice reversal candles. It is of course too early to say whether this will really be “it”. What we want to say, however, is that this time the bounce has a different feel attached to it: it just seems to us to be a bottoming process. A weekly close above 1400$/oz. for gold would most likely seal the deal in our mind. In any case, investors are now presented with an excellent opportunity to increase their exposure to this asset class. Sentiment of course is in the gutter, with newsletter writers now recommending a record-breaking average short position of 44% according to Hulbert Financial Digest and with Sentimentrader’s public opinion survey now showing widespread bearishness. Positioning shares sentiment’s place in the gutter, with small speculators almost net short in gold and with the lowest exposure ever to silver (and this does not even reflect the recent plunge). Moreover, if one spends a bit of time lurking around in forums and blogs, then he’ll certainly notice that most people there are talking about shorting PMs, increasing their shorts etc. (nobody is talking about selling their longs as they already did during the last crash).

A chart of gold via Stockcharts: notice the reversal, accompanied by momentum divergences.

The reversal (after fresh new lows) is even more evident in the case of silver.

Conclusion

We cannot possibly know whether the bottom is in or not, but we know that the fundamental arguments used to support bearish views are fallacious and that sentiment and positioning both scream for a bottom (although in all honesty they have been screaming for a while). We now have a reversal that looks convincing and we have to make do with it. We are buyers, knowing that the rewards far outweigh the risks and more importantly knowing that the secular bull market has not ended, not by a long shot, and that as such being long here is a sound proposition likely to deliver excellent returns over the coming years. Of course, readers need to remember the importance of using their own brains and of prudent risk management (read: don’t be heroes who leverage to the hilt in hope of becoming the next Paulson).

Burning Down the House

The goal of this post (whose title is again going to titillate music aficionados) is to give our readers a quick overview of the state of roughly 20 real estate markets around the world. We’ll purposefully omit countries where the bubble has already clearly burst (like Spain, Ireland or Cyprus), although in many of them the downside may still be severe. A notable exception is the U.S., where the savvy policies of the bearded monetary shaman have helped bring the housing bubble back from the dead.

Germany's housing market so far hasn't managed to enter bubble territory, although the recent influx of scared money, coupled with the ultra-loose policies of the ECB are beginning to work their voodoo.

We intend to start with a brief Austrian explanation of the origin of bubbles and how come they often manifest in the RE sector and we’ll then move on to the actual description of the various RE markets, for which we’ll use a combination of statistical data, third party research, anecdotal evidence and direct experience (we’ve been to many of the countries mentioned and we’ve also had a stint in the construction business a few years ago). It’s worth noting that we’re currently short via long-dated put options (although a paper we recently read and on which we may comment in a subsequent post has had us reconsidering the wisdom of buying long dated options, rather than continuously roll-over short-dated ones) a few banks such as CBA in Australia, BNP in France, RY, BNS and CM in Canada: they’ve been binging on RE during recent years and we suspect they won’t be cheering once it becomes obvious that the party is over.

As an aside, we still have to understand why exactly perpetually rising real estate prices (in the face of massive oversupply to boot) are held to be such a boon for an economy, as they only bring about more debt and/or a decrease in disposable incomes as they keep on tying up more and more resources.

On the Origin of Bubbles

Unless one believes that bubbles are a “gift” of God or the inevitable result of the evil capitalists’ activities, the first thing one has to ask himself is “How come there are bubbles?” and the second one is “How come they always (or at least very often) seem to appear in certain specific sectors of the economy (like e.g. real estate)?”. The answers to these very important questions lie in the thorough study of the theories formulated and expounded by the Austrian School of Economics and in particular by its two heavyweights Mises and Rothbard. If one does not wish to read roughly 2.500 dense pages of actually very sound and interesting economic thinking, then we can suggest him to at least have a look at this great article on the production structure assembled by the always excellent Pater Tenebrarum, whose blog we highly recommend and on whose work we’ll rely rather extensively during the course of this post. Here, we’ll just give a short, to-the-point answer to the questions above, simplifying and summarizing more complex concepts that inevitably need other venues to be treated exhaustively.

First of all, we need to recognize the fact that the production structure (i.e. the productive chain that starting from raw resources and labour delivers a final consumer product) is made up of different stages: higher order (like e.g. real estate, the capital equipment industry etc.) and lower order ones (like e.g. your grocer around the corner). These stages are defined according to their distance from the final consumer goods the production of which is always the ultimate goal of the economy: all factors of production, whether original (land/natural resources and labour) or produced (capital goods) are always employed to produce a final consumer good somewhere down the road (i.e. a trashing machine being built today with the use of raw resources and manual or mechanical labour will one day harvest grains that will then be consumed as food). It is important to note that there exists a lag between the beginning of the production process at the highest order and the actual production of the final consumer good (i.e. you can’t produce an iPhone if you haven’t designed it or built the necessary tools and machinery needed to assemble it). The longer the production structure, the longer the lag. It obviously follows from this fact that all investments in the production structure need to be funded by real resources that have already been both produced and saved (since the additional consumer products that will be produced as a result of these investments won’t be available before a certain lag); also, the financing of higher order stages of production requires significantly more resources than the financing of lower order ones, due to the fact that it takes longer for them to yield a final consumer good with which to repay the investment. In the trashing machine example above, we already need to have the grains with which to feed the labourers employed in its construction: we can’t make them work without subsistence whilst waiting for the machine to be completed and the next harvest to begin, no matter how loudly Paul Krugman argues for such an idiotic approach (by the way, we’d love to see him starve whilst trying to prove that you can indeed put the cart before the horse). Money simply facilitates this process: instead of paying our workers with grains, we give them money and they’re free to spend it according to their needs and wants. But the fact remains that we can only fund production with real resources and the appearance of fiat money (via printing and credit expansion) does not magically make appear real resources as well.

That said, how do we go about deciding the allocation of resources between the different stages of production (i.e. how do we decide whether to invest more in harvesting machines or whether to keep harvesting by hand or even whether to further lengthen the structure by investing in the designing of a plant that will produce new and more efficient tools to facilitate our harvesting)? It all depends on our time preference rate, that is it depends on our willingness to sacrifice present consumption (that we need to save to finance investments) in favour of higher, but future consumption. Each one of us of course has his own personal preferences and in a complex market economy where many economic actors interact all these different preferences combine into forming the originary rate of interest (which is nothing but the society-wide time preference rate), in the same way in which buyers and sellers combine in forming the market price for a good. This originary rate of interest is not set in stone, but rather changes as conditions (like e.g. the size of the pool of real funding) and preferences change, again in the same way as prices do. [For the sake of simplicity we omit to mention here the fact that each and every good has its own specific rate of interest and that there exists a never-fulfilled tendency towards the harmonization of all these different rates.] Originary interest combines with a risk premium (dependent on the creditworthiness of the borrower), a price premium (dependent on the expected changes in the purchasing power of money) and an entrepreneurial profit to form the interest rate.

With the above in mind, we can now begin to see how bubbles come into existence and the sectors in which they are likely to occur. The investor who needs to allocate capital (i.e. real, saved resources) relies on the interest rate to facilitate his calculations of which allocations are profitable (by discounting in the present the future value expected to be generated by the various investments). He also uses money as a unit of account and its availability as a proxy for the availability of the real resources this money is supposed to represent. We can now realize that if the money (or credit) is not backed by real resources, if its value is subject to a constant, subtle erosion and if the rate of interest does not truly reflect the real society-wide time preference rate then the investor can very hardly avoid making a mistake in his calculations.

It also becomes clear that the higher stages of production will be affected more by such interferences than the lower stages as the lag between an investment in such stages and the actual production of the final consumer goods is greater and this makes its profitability significantly more dependent from changes in the rate of interest (since the period to be discounted using that rate is longer).

Recalling the fact that investing in higher stages is more resource-consuming, we can see how these false signals that encourage investments in these higher stages in the absence of the required amount of saved-up resources are especially pernicious, as they deprive the economy of significant amounts of real capital that may have been used to satisfy far more pressing needs (as an example think of all the stuff that gets used up and all the people that are employed when building one of the famous “stimulative” bridges to nowhere). Moreover, when it is discovered that the required resources the existence of which was feigned do not actually exist, the re-adjustment process becomes inevitable (i.e. the bubble bursts).

Proof of our assertions can be found in the fact that, as far as we know, we have not once seen or heard of a bubble in greengroceries, with people rushing to open up stores to sell apples and bananas to frenzied consumers (as the grocer buys the groceries wholesale at dawn and sells them throughout the day and does not need any particular capital equipment to carry out his job, he is basically immune from manipulations of the rate of interest, although as readers can see in the article linked in the next paragraph overconsumption takes place during a boom as well and is then inevitably followed by “forced savings” and this inevitably affects the latter stages). On the other hand, we’ve been to many cities with office and residential towers popping up like fungi and where we could see a real estate agency on every corner (or even more often) and meet deluded people who were happy to share their dreams of boundless wealth (of course, they only needed RE prices to go just a little bit higher).

We want to make an additional and apodictic consideration (although we do provide a link here for those who want to further examine the argument): the stage of the production structure most neglected during the boom phase is the middle one.

And with this we end our brief introduction, again stressing the need for way more thorough investigation of the matter on the part of interested readers.

Old Europe

Let’s begin with where we live, the wonderful continent of Europe. Readers interested in knowing more about it, in a heavily stereotyped (and hence fun) way, can watch “Jeremy Clarkson meets the neighbours”: here is the link to episode one!

Netherlands

Here we start with a massive one! It seems to us that the Dutch are suffering from Tulipomania-related nostalgia and as such have been busy blowing a new bubble, and one for the ages!

Household debt to GDP as well as household debt to disposable income ratios of 250% and skyrocketing home prices: an explosive combination! The end result is one of the most overvalued RE markets in the world, that lately clearly appears to be faltering. With 650 billion € of RE loans outstanding, stockholders, bondholders and depositors at Dutch banks beware: you may get Cyprus’d before you know it, as our beloved Reggie often reminds to the Irish!

Interested readers can find more info here, here, here and here.

Two Charts depicting the performance of the Dutch housing market in recent years, via Global Property Guide.

A wee bit of debt currently on the balance sheet of Dutch households, from the previously linked Acting-Man post.

France

Ze French would obviously not tolerate to be left behind by anybody (ah, la grandeur!) and so here we have them, with their RE market right on top of the list of the most overvalued in the world. Depending on the valuation measure used (whether disposable incomes or rents), prices are roughly 35-50% above their long-term average ratios, which means that, according to the law of the pendulum, they are likely to go quite a bit below said average ratios once the bubble pops. We wouldn’t be surprised to see prices at least halve over the course of the coming years, particularly if Monsieur Hollande keeps acting like a lunatic (let’s be honest: he looks like one, doesn’t he?! Have a look here!). It’s interesting to note that in Paris and in the surrounding region overvaluation is even more extreme, likely due in part to the economic and political importance of the area and in part to the huge influx of foreign money (this resembles the situation of London in the U.K., see below). No Pétrus for recent buyers, that’s for sure! A marked slowdown in building activity and a recent decline in sales (which turned into a 44% plunge in the number of transactions in Paris), accompanied by a modest reduction in prices may signal that the party is rapidly ending (readers need to remember here that prices are the last component to deteriorate, with construction activity and more importantly sales acting as early-warning signals). Interested readers can learn more here, here, here, here and here.

French home prices relative to disposable income, divided per region, chart courtesy of CGEDD.

Belgium

Even the tiny country of Belgium has managed to blow a rather sizable RE bubble, with remarkable levels of overvaluation. Interestingly, the market seems to be giving only feeble signals that the unwinding process may be about to begin: prices continue to creep higher (albeit not in Brussels), with the only warnings being a slowdown in construction activity and a decrease in mortgage issuance. We do however doubt that the Belgian bubble could be able to withstand a popping of neighbouring bubbles (France and Netherlands) and/or a new iteration of the global financial crisis (which, as readers of this blog know, we consider to be baked in the cake). Interested readers please have a look here and here.

  Belgian house prices: still no sign of collapsing. Chart via Global Property Guide.

U.K.

The U.K. also sports a severely overvalued RE market, with London being one of the most expensive cities in the world when it comes to buying a house. Prices are at least 30% above their historic valuation ratios. Of course, British blokes are up to their eyeballs in debt (in the Greater London area mortgage servicing takes up on average a whopping 35% of income). And quite naturally the government feels compelled to encourage even more reckless borrowing (we want to reassure the author of the linked article, as there’s no risk of creating a new RE bubble: there already is one that is alive an well!). So far no major warning shots have yet been fired by the market (although there has certainly been a slowdown), however we encourage current RE owners not to feel too safe, as the foundations of the bubble are clearly shaky ones and a new recession or a financial shock may very well prove to be the proverbial nail in the coffin. Other, more detailed information can be found here and here.

 

The dizzying chart of U.K. real estate prices, via Global Property Guide.

Switzerland

Even the famously dull Swiss have not resisted the temptation of engaging in a massive real estate binge, thanks in part to the mental policies of the SNB (zero rates and a money printing bonanza designed to stop the “harmful” rise of the Franc) and the large inflows of scared foreign money in search of a safe haven (and which may have ended up finding a grave). The result is a horrendously overvalued market where interest-only mortgages are common practice (otherwise many chaps could not even begin to think about buying a home) and where many cities and popular resort towns now sport some of the highest prices per square meter of the whole orbis terrarum. And so the secluded alpine country, famous producer of excellent chocolate and cuckoo clocks of dubious taste, is now drowning in debt, to the tune of 175% of disposable income. Again, there are no clear signs that the end may be approaching. In fact, it seems like the bubble is currently accelerating into its final blow-off stage. Readers are invited to read more here, here, here and here.

A chart of RE prices in Switzerland, which conceals the astonishing increases witnessed by some of the major cities.

Sweden

Even the supposedly safe Northern European countries have taken part in the global RE bubble and they’ve done so with much gusto, as we shall see here. Starting with Sweden, we want to mention that prices have now begun to decline moderately, after having experienced an incredible run-up (more than doubling in the last decade). However RE is still severely unaffordable and at the very least 20% above its long-term average valuations. A household debt-to-income ratio of roughly 175% completes the picture. Signs of a slowdown are now present, but not yet obvious. For more on the topic please click here, here, here, here and here.

Housing prices in Sweden: now beginning to decline after coming close to a triple in less than two decades.

Norway

Norway is not in much better shape than Sweden. Arguably, the situation there may even be worse, due to the fact that its bubble has grown significantly larger than Sweden’s. Proof can be found in the fact that households now sport a debt-to-income ratio grater than 200%, not to mention that RE prices may be as much as 70% above their long-term averages, depending on the valuation metric used. Socialist paradise anyone?! Particularly worrying is that fact that so far there have been few if any signs of More facts can be dug up here, here, here, here and here.

Honestly, we can’t see a bubble here, can you?! A mere tripling in 15 years can’t count as one! Via Global Property Guide.

Denmark

Apparently even the almost inconsequential country of Denmark has managed to blow its own RE bubble and to make sure it was noticed abroad it made it egregious. Maybe exponentially-rising home prices have helped the Danes cheer up a bit, but don’t hold your breath for it. In any case, the solution to the supply-demand imbalance appears simple to us: just build a few Lego houses! Household debt is more than 300% (yes, that’s not a typo) of disposable income and house prices have almost tripled in the last 15 years. Also of note is the sheer size of the nation’s mortgage market: 600 billion € ready to blow up in the face of not very smart holders. The bubble here has clearly burst and the real fun is just beginning, as both the government and the banks scramble to find a way to keep the ponzi scheme going. More info here, here, here, here and here.

The party has clearly ended in Denmark: now it’s a question of who’s going to eat the losses. Chart via Global Property Guide.

Finland

We terminate our overview of European RE markets with Finland, which also has its home-made bubble, although maybe less egregious than those of its neighbouring countries. Debt-to-income is “only” a bit above 100%, but home prices have almost tripled in the last 15 years. As of late the bubble seems to be wobbling, with price appreciation having slowed down markedly. Readers can continue their research here, here and here.

House prices in Finland, via Global Property Guide.

Down Under

We now move to the Southern Hemisphere.

Oz

Australia is where one of the most egregious RE bubble in the world has popped up, thanks in part to the commodities boom and to an enormous credit expansion. Houses are now at the very least 30% overvalued (with 40% to 50% being a more credible estimate), with cities such a Sidney sporting some truly ridiculous prices. Household debt stands at 150% of disposable income and most of it is mortgage debt, which the fractionally-reserved banks have very generously offered to the usual muppets who could ill-afford it. No problem though: skies are clear and prices keep on rising like there’s no tomorrow! Actually, they don’t: prices have stalled and have now begun to decline, although at a moderate pace. Their decrease is accompanied by a sharp decline in the number of sales and a marked slowdown in construction activity: it seems to us that the unwinding has begun, particularly given that China is now beginning to crumble as well (more on the topic below). Plenty of links for the passionate investigators: here, here, here, here, here, here, here, here, and here (where the author shares his delusion that prices cannot possibly collapse since, among other things, they may have “plateaued”: 1929 anybody?!).

Prices in Australia have now begun their long trip down, via Global Property Guide.

Debt to disposable income ratio for Australian households: pretty high and most of it is mortgage debt. Chart from one of the articles linked above.

New Zealand

Apparently, the Aussie’s neighbours aren’t doing much better. In fact, it seems they’re currently experiencing the final stage of the bubble, with relatively brisk price increases across the board and some signs of a looming slowdown. Of course, the debt to income ratio stands at a quite buoyant 150% and prices are at least 25% overvalued, but may be as much as 65% more expensive that their long term average. Our guess is that when the Australian housing market finally sneezes the NZ is going to catch a cold. More information can be found here, here, here, here, here, here, here and here (again, delusional – or maybe self-serving - comments about the non-existence of the bubble).

NZ house prices, via Global Property Guide. And they have the audacity to claim that there’s no bubble?!

Here we have the usual wee bit of debt. Via one of the previously-linked articles.

South Africa

We have decided to include South Africa simply because we had the chance to visit it right at the height of its massive RE bubble and we enjoyed looking at then-current listings (referring to them as totally ridiculous is a huge understatement) and chat with a few chaps there about the market and we returned home deeply satisfied, with the persuasion that the market was headed for a decade or more of Buddhist-like nothingness. And in fact it seems like we were spot on, as prices have gone pretty much nowhere during the last few years, notwithstanding a relatively significant depreciation of the currency. But now it seems like the globalized inflationary race has begun to work its wonder on SA as well, with prices again starting to increase at a quite rapid pace. Whether this is just a temporary phenomenon or the beginning of a new bubble still remains to be seen. In any case, as much as SA is a lovely country, we wouldn’t buy a home there. Debt to disposable income stands at 76%, but remember that a large part of the population cannot possibly think about borrowing as they’re too busy surviving. Further info can be accessed here, here, here, here and here.

                                                             

House prices in SA and YoY % change in nominal and real terms, via Global Property Guide.

North America

We’ll now quickly review the state of the housing market in the U.S. and Canada. It’s worth mentioning that Bernanke is “successfully” (depending on how you define success) re-inflating the once-burst U.S. housing bubble. Of course this is bound to generate even deeper distortions and dislocations in the economy’s structure of production. It won’t end merrily.

U.S.

The witch doctor, alternatively known as Fed Chairman, Ben S. has managed to re-start many bubble activities that were justly interrupted in the wake of the 2008 collapse. Of course this has happened at a grave cost, as unsustainable and ultimately unprofitable capital-consuming activities continue to be allowed to take place, at the expense of everyone in the economy. Housing is of course chief amongst these bubble activities and the market has experienced a strong rebound. Whether it’s going to survive the coming crisis is of course highly questionable. In the meantime, ever more people are getting sucked in, ready to be spit out in pieces once the downturn arrives (and it always arrives, although it often takes longer than anticipated). It should be clear that this whole process does nothing but inherently weaken an economy. Anyway, let’s review some data: debt to disposable income stands at 115% (whereas household debt to GDP currently is close to 90%), home prices are increasing at the fastest pace since 2006 (which was pure bubble territory) and median nominal prices for new homes are again at levels close to those registered at the last bubble’s peak. You draw your own conclusions! Here, here, here, here, here, here and here readers can find more information. Moreover we recommend this blog and all the articles published at Acting Man by guest author Ramsey Su.

U.S. home prices have begun to creep up again: a new bubble is forming? Via Global Property Guide.

Median U.S. new home prices: back in bubble territory. Chart taken from this article.

Canada

Here we have another contestant for the top prize in the category “Most overvalued RE market in the world”! Again, the culprit is the reckless monetary policy of the central bank, which has allowed bank credit (i.e. credit that is not backed by real resources) to boom. The global commodities boom has also helped in fuelling the bubble. The result is that now Canadian households have a debt to income ratio above 160% and home prices are at least 35% overvalued (but the figure may very well be significantly higher, maybe even in the vicinity of 80%). Warnings signs have begun to appear as of late, with construction activity slowing down, sales number continuing to significantly deteriorate and a series of six uninterrupted monthly price declines. More information can be found here, here, here, here, here, here, here, here, here, here, here, here, here, here, here and finally here (look at his bright face and then ponder whether his “well-reasoned” arguments hold any value).

Canadian home prices via Global Property Guide: up, up and away!

Rest of the World

Let’s now quickly review the state of the housing market in a few more countries, before drawing our conclusions. We wan to to briefly mention that both Dubai and Hong Kong, by keeping their currencies pegged to the U.S. dollar, basically adopt the Fed’s monetary policy. As a result, their RE bubbles are sort of echo bubble, magnified by the relatively small size of their economies and by the huge foreign capital influxes. On the other hand, both Singapore and Hong Kong sport very low taxes and a remarkable level of economic freedom and are thus engaged in true wealth generating activities, which to a marginal extent mitigate the impact of the bubble.

Dubai

We couldn’t avoid mentioning Dubai, as it’s arguably the most absurd place on the earth, a big playground for His Highness Sheikh Mohammed bin Rashid Al Maktoum, a child at heart with gobs of money at his disposal. "The word 'impossible' is not in leaders' dictionaries. No matter how big the challenges, strong faith, determination and resolve will overcome them.". Sure, we mere mortals can’t argue with such words of wisdom, but in the meantime we humbly suggest to include the world “bubble” in the aforementioned dictionary (“debt restructuring” is already in it). Oh, and we happen to have a nice bridge to sell, should His Highness be interested!

We were in the city of dreams (which may become nightmares) recently and we were delighted to see cranes all over the place: 2008 hasn’t taught the morons a thing! In fact evidence seems to suggest that there currently is a new speculative mania underway in Dubai’s property market. Proof of the foolishness of such RE frenzy lies in the sheer number of empty units. Again, we seriously doubt it could survive a resurgence of the 2008 financial crisis. The only mitigating circumstances are the absence of taxes and the relative degree of economic freedom, which, in an increasingly more totalitarian world, appear as ever more valuable features. More info here, here, here, here, here and here for a bit of colour!

Singapore

Singapore is another very overvalued RE market (with the only caveat mentioned above), with prices roughly 50% above their long-term average according to The Economist. Signs of a slowdown are present, although we haven’t still heard a clear popping sound. Interested readers can have a look here, here, here, here and here.

                                               

                                           

House prices in Singapore and their YoY % change, via Global Property Guide.

Hong Kong and China

Hong Kong is probably the single most overvalued RE market in the world, with Canada the only true contestant for the top spot. Prices there have tripled in less than a decade and are now roughly 70% overvalued. We explained the dynamics of the bubble above. We just want to add that the market is now in a manic blow-off stage, with prices increasing more than 20% in the last year. If we had a house there we would be rushing to sell it, not now but yesterday! Further information can be found here, here, here and here.

                                           

                                                 

Hong Kong RE prices and their YoY % change: a sheer bubble is glaringly obvious. Charts from Global Property Guide.

China is a bit of a different story, quite complex and murky. We won’t analyze the market in detail here (although we do not rule out doing it in a future post): we’ll just provide some basic info and a quick overview. Real estate speculation is the national sport there and it’s also the main tool the all-knowing wild bunch of bureaucrats ruling the country uses to achieve the desired level of “growth” (i.e. an orgy of malinvestments mistaken for a mirage of prosperity). Leverage is also present in spades, notwithstanding the usually benign official statistics, thanks mainly to the so-called “shadow banking system” (i.e. a colourful potpourri of moneylenders, pawnbrokers and loan sharks). The picture is completed by the by-now famous “ghost cities”, imposing monuments to the utter madness of which humans are capable. Signs of a slowdown are present, but not yet unequivocal. It is however important to note that our Mandarin friends do not stand out for their transparency. Interested readers are welcomed to learn more here, here, here, here, here and here.

Property prices in China have experienced a “healty” increase in the last decade, via Global Property Guide.

An interesting documentary on China’s ghost cities.

Conclusion

It should be clear by now that the world at large is in the midst of an egregious real estate bubble (actually bubbles are pretty much everywhere and not only in RE, hence Jesse Colombo’s apt definition of this epoch as The Bubble Bubble, a bubble of bubbles). We have of course not covered all the countries in the world, but readers should have developed a taste for what it’s like. Those who are willing to spend some time doing further investigations can take a look at India or other emerging markets and see whether they can see any differences with the countries presented above. The takeaway is clear in our opinion: wherever you are, think twice before buying a house! Interesting speculative opportunities also abound, as shorting the stocks of banks that are heavily exposed to bubbly RE markets is likely to prove profitable, provided it’s done in an intelligent way. Exercising patience is always necessary though, as many of these bubbles could keep on going for quite some time, especially given the reckless policies currently implemented by global central banks (and we have them and their fractionally-reserved cronies to thank for this mess). Warning signs abound in many cases, but timing is always the tricky part. And of course there’s no substitute for doing your homework.

As a final note, we’re generally not prone to self-praise, but assembling this post has really been yeoman’s work and we hope that our readers will appreciate it and if so help spread it to a wider audience.