Real Estate, Bonds, the Economy and Other Ramblings

Real Estate - A Quadruple Bubble -

Is the real estate market in a bubble, or perhaps a series of bubbles? I do not have sufficient statistics to back up this thought so it is only a theory at this point... but it looks to me like the domestic real estate bubble has already peaked (bubble #1). But we have not witnessed any significant price decreases because the falling US Dollar has made US real estate appear to be a bargain for foreign investors (bubble #2). One local realtor I talked to recently told me that their office has had a substantial increase in interest from buyers outside of the US. At the same time the number of fixed-interest mortgage primary-residence US buyers have been steadily decreasing for several months. The US buyers that are still quite active, however, seems to be those using ARM's (adjustable rate mortgages). Home buyers using ARM's now outnumber buyers with fixed rate mortgages. These include first-time home owners who otherwise could not afford to buy a home (bubble #3) and existing homeowners that are buying second or vacation homes, and house speculators (bubble #4).

Doug Noland: "...ARM behemoth GoldenWest Financial enjoyed a strong November. Originations were up 26% from November 2003 ... For the month, 99% of mortgage originations were adjustable-rate, with refinancings accounting for 75%..." (12/23/2004).

(CyclePro Comment: these stats need to be taken in context, GoldenWest is a leader in ARM financing therefore the vast majority of their financings should be ARMs. However, the mere fact that originations are up year-to-year shows that portion of the real estate market has grown and is still quite strong).

Local advertising tempts home buyers with an opportunity to purchase $250,000 homes for as little as $600 per month. Companies like further tempt homeowners with low interest home equity loans to: pay off debit cards, buy cars, education, or to spend on anything!

First-time homeowners with ARM's and late-to-the-party speculators will be the first of the bubbles to burst because they have the thinest variance for increased monthly payments. I believe the families that were most likely to be enticed by ARM's are the ones who otherwise could not afford to buy a home with a fixed rate mortgage. When interest rates rise, monthly ARM interest will also rise, thus raising the monthly mortgage payment. If interest rates rise further, it is possible for ARM rates to exceed fixed rates. If families could not afford fixed rate mortgages when they wanted to buy a home in the first place, then if/when rates rise far enough, they will be forced to give up their homes or find alternate financing schemes.

Once foreclosure numbers start to accelerate it usually means the snowball is already rolling down the hill and cannot be stopped. Foreclosures put downward pressure on home prices. As market prices begin to fall, mortgage holders may find themselves in a situation where their outstanding loan balance is higher than their home market value. This is particularly likely with ARM's because almost none of the loan principle is paid off early in the loan.

I saw this first hand when I originally moved to Houston, Texas about 18 years ago. I knew people that simply walked away from their mortgages because they owed far more than what the house was worth.

When market prices fall, speculative owners try to sell their properties and that puts additional downward pressure on market prices.

One of the statistics to look for is how often sellers lower their listed asking price. The greed factor along with human nature and unbridled optimism is to chase market prices lower with listed asking prices that are not quite low enough to generate adequate interest.

Another interesting statistic is the ratio of buyers Vs sellers. Certainly over the past several years there have been more buyers than sellers. Once the number of sellers exceeds buyers, we will know that the bubble has burst and prices should drift lower. And that will cause all real estate bubbles to break down.

Here's my take on real estate ownership in the environment that I believe we will see over the next 6-8 years. How far home prices will fall no one knows for sure, but they will fall. Home prices, just like any supply-demand commodity, rise and fall in cycles. Having equity in your primary residence is the best defense because it provides a cushion against falling market values. Although that may sound depressing, the fact is that the more cushion you have the less likely that you will be forced to bail before market prices recover. Refinancing's have been a fad over the past several years because of extremely low interest rates, plus the enticing advertising media that suggests you should extract your home equity in pursuit of short-term enjoyment. And to make matters worse, many offers were made at more than 100% of equity, I often saw ads for 110% of equity. I don't have any problem with enjoying life, but using a long-term financing plan such as standard home refinancing, means that once your fun has ended you are still stuck with paying it all back over a very long period of time. To make it worse, you have tied it to your home so if/when financial times get tough, you have dramatically increased the possibility of losing your home. For those that took out more than 100% of their equity, the downturn in market prices may be particulary sour.

As an example that I saw in my old neighborhood before moving from Houston, TX, people were using home equity refinancing to buy fancier cars and SUVs to keep up their image vs their neighbors. The equity in the home grew as market prices in the neighborhood rose. Financing for autos is quite attractive right now so that should be the best option. If down the road your cash flow gets tight, it is far easier to give up the SUV than it is to give up the house. When you lose your house, you lose everything.

One final note is that it is well known that a lot of the earlier home equity refinancing cash went into the stock market. A lot of investors still hold to their belief that stocks are low risk investments. Stocks purchased from refinancings that used ARM's may be at risk as interest rates rise. Higher monthly payments on those loans means that the stock price must increase or else the higher loan payments may squeeze household budgets. Squeeze tight enough and they will be forced into selling some of those stocks.

Crude Oil has done just what I had talked about 18 months ago, except however, my $40 target was surpassed when West Texas Intermediate traded as high as $56. Right now prices have backed off, but where $40 crude was almost unthinkable 18 months ago, now people see $40 as a relief, and an acceptable level. Gasoline prices at the pump have also retreated to sub $2 levels although diesel remains about 40 cents higher. Our local Sam's Club is currently selling regular grade gasoline for $1.77/gallon.

It is doubtful that we will see crude below $30 over the next several years. President Bush is unlikely to release oil in SPR storage (Strategic Petroleum Reserve) as long as there are conficts in Iraq and other "Axis of Evil" countries remain to be processed by his preemptive idealogies. Further, China continues to be a big buyer of crude on the international markets, partly to provide energy for their manufacturing industries, but also to stockpile (similar to our SPR) for their own military needs (ie: Taiwan).

If Bush were to simply announce that he might "consider" releasing SPR oil (even if he really has no intention to do so), I have no doubt that the futures trading for Crude Oil would drop by $2-3 per barrel almost instantly.

US Bonds Below are 2 updated charts showing that my previous forecast was right in both price an time (from point "d" to point "e"). However, the highs in Bonds have since moved slightly higher yet even though the overall pattern remains mostly sideways at these levels. The current pattern is suggesting that Bonds could remain above the upper blue line as support. This portends the possibility of prices moving higher (yield moving lower). Of course this is exactly opposite of my overall viewpoint for inflation which would expect Bond prices to begin falling soon (yield moving higher). This situation requires a patient and casual monitoring of Bond performance, so a knee-jerk trading opportunity is not warranted at this time. As long as Bond prices stay above the upper blue line, a 1929-1932 style crash cannot occur.

Please note that the labels on these charts are not Elliott Waves, they are intended to align the waves in the current charts with those of a similar US Bond chart from 1929-1932 that I posted earlier.

China It is important not to ignore potential scenarios where such a Bond crash could occur. For example, China holds nearly $1/2 trillion in US Bonds and Treasury Notes. Likewise, there are many central banks that hold their reserves in US currency, bonds, and treasuries. I think China is already the principle financial power of the world right now, the US and Europe are in denial if they believe otherwise. The more the US Dollar weakens, the stronger China becomes. How much of China's reserves (in US Bonds) would have to be sold in order for the Bond chart to replay the same 1929-1932 pattern?

If China were to cash in their bonds and demand payment in gold rather than fiat US currency, what do you suppose would happen to the Dollar? Gold prices? the Yuan? Ha! got you on that one, because at current prices there is not enough gold in existence to pay off all of China's holdings of US Bonds! Because of a shortage of freely traded and available gold inventory, prices would likely need to increase by perhaps 8x or more to make enough gold available to pay China. An interesting thought perhaps, but doubtful.

If China wants to cash in their US Bonds, the most likely scenario is that the US will merely crank up the printing presses and create more Dollars as needed... inflationary, of course, for the US.

Here's one scenario that I think has potential: China makes a military move to regain control of Taiwan and asks the US to butt out. Of course the US does what it can to defuse the situation, but China holds the trump card. China can (and probably would) cash in their holdings of US Bonds & Treasuries and ask for immediate payment. If the US refuses to back out, the Bond chart plays out the crash scenario. If US backs down, their reputation as a superpower is forever tarnished. Plus, since so much military energy and budget is currently focused on Iraq, how much remaining military strength does the US have to also take on the defense of Taiwan?

Let's be realistic abouth this scenario - what is more important to China right now? I think China feels they are self-sufficient enough that losing trade with the US is a very low risk. If US stops buying Chinese products, then US prices for products manufactured in China would go up - big time inflationary. The decision about whether US would continue buying Chinese products may not necessarily lay with the US, rather it could be that China makes the decision (or threat) to NOT export to the US. Whether that actually happens is questionable.

Another thing China has to their advantage, also currency related, is their current peg to the US Dollar. China can choose to allow their currency to float at any time. The instant that is announced, the US Dollar may fall while the China Yuan (renminbi) should rise - probably substantially. The US has been trying to convince China to float their currency, but it is kind of like the old saying about being careful what you wish for because you might just get it. If the Yuan peg to the Dollar is removed, almost instantly, prices for Chinese-made products will rise in the US. While this would make domestically manufactured products more price competitive, rising prices cascades through nearly all goods and that means inflationary pressure across the board.

If the Dollar falls enough, other countries that currently hold Dollars as central bank reserves, may decide to bail out of the Dollar so it does not drag their own currencies down. Even countries that simply peg their own currencies to the Dollar may decide to allow their currencies to float. The most likely US financial defense would be to significantly raise interest rates (which correlates to significantly lower bond prices).

Now it is clear that China holds not one but three trump cards: (1) Remove Yuan peg to the Dollar (US inflation), (2) Cash in their US Bonds (US interest rate rise, US inflation), (3) Threaten to stop exports to US (US inflation).

Warren Buffet: "...the electorate of the U.S. may be strongly tempted to get out of hock by inflating away the country's dollar debts..." ( 12/28/04)

If I can read between the lines of Mr. Buffet's comment, it may be entirely feasible that if a situation like I have described above were to present itself, the US may secretly encourage a China-induced US inflation rather than actively attempt to fight it. That would paint China as the party pooper and get Alan Greenspan & George Bush off the hook.

China is scheduled to host the 2008 Olympics. Would they risk losing world support? If not, would they merely wait until after the Olympics is over? Probably not since their strength is now while the US is weakened with Iraq - by 2008 the US involvement in Iraq may be much less than it is today. If you think US will be completely out of Iraq by 2008 then you may be in denial.

Stocks - In the original CyclePro big picture, we were looking for a massive 3-wave decline following the 2000 peak. The first & 3rd waves are down waves while the 2nd wave is a counter-trend rally of which we expected it to be of a complicated pattern. I recall saying that this period would be a traders paradise because prices were likely to stay within a wide trading range allowing traders to take advantage. Most investors are not traders, so I think an unwavering bullish bias has kept most investors on the buy-side. Each of the various stock indexes have exhibited varying patterns.

In the same way that the declining Dollar has helped the housing market by allowing foreign investors to buy at percieved "bargain" prices, so too are other assets denominated in Dollars, inclusing US stocks. I believe a substantial portion of the market rally (particularly since October, 2004) is directly related to foreign investment. Since October the DJIA has rallied in near-perfect inverse relationship to the declining Dollar.

Below are two charts for the Russell 2000. The left chart is monthly showing the 2000 peak and the subsequent complicated correction. From October, 2002 the Russell 2000 has rallied in 5 clear and distinct Elliott waves, surpassing the 2000 peak. The right chart is daily to show the detail of the final wave structure. The move up from August, 2004 also appears to be a structure of 5 waves.

The DJIA has not yet rallied far enough to surpass its 2000 high, yet its chart also shows a 5 wave rally pattern from the same October, 2002 lows.

This sets up for a perplexing situation. Our big outlook was for a 2nd wave rally (out of the 3 waves for the total corrective pattern). Since we have a clear 5 waves up it means one of the following scenarios:

1) The move down from 2000 peak was only a complicated correction and now the 5 waves up suggest an even higher completion pattern for the 20+ year bull market in stocks. This is quite clear in the Russell 2000 chart. If this were to mean higher prices then we would need to see a confirmation by the larger indexes, such as S&P 500 and DJIA. Without these comfirmations, it could mean that the Russell 2000 is signalling a final exhaustive hurrah in the long bull market while the other indexes resume their already bearish path.

It is quite common for one index like the DJIA to peak early and not make new highs such that in corrective patterns, another index like Russell 2000 does make new highs where it patterns line up with the DJIA, yet only the broader index actually makes the higher high. This would suggest that big-cap stocks, traditionally the bellweathers of the market, are lagards that hold the entire market back.

The Russell move down from the 2000 highs does not appear to be impulsive at all, thus supports this scenario. Since the weekly Russell 2000 charts shows 5 waves up from the October, 2002 lows and it's 5th wave (as shown in the daily chart) is also comprised of 5 waves up, and it appears that its 5th wave may also be comprised of 5 waves (with perhaps a tiny bit further to go), then all of that may be a loud signal that the entire market is finally topping out. Ie: the Russell may be completing its overall 20+ year bull market at the same time the DJIA is completing its 2nd wave rally within a much larger 3-wave decline.

The Russell 2000 may soon begin its initial corrective waves down in a major bear market while at the same time the DJIA begins moving down for its 3rd wave within a bear market that began in January, 2000.

When we get to the bottom of this bear market we should see the opposite non-confirmation scenario, ie: the DJIA should be the first index to emerge with impulsive rallys while the Russell 2000 continues to work through its final bear market routs. This change in trend may take several years just like the topping activity has for Russell and DJIA. If I am right, then the next 6 years are likely to be a cascading series of lower-low selloffs for all stock indexes. That followed by several years of transition, then the beginning of the next major US stock bull market - sometime around 2012 (or between 2011 and 2014 depending upon the index).

2) The S&P 500 and Nasdaq charts do not appear to be corrective from the 2000 peaks - they very much look like downward impulsive moves. The S&P 500 has recovered just over half from its lows and the Nasdaq only a third. Yet, the rally from October, 2002 lows has the look of an impulsive 5 waves. The likelihood of these indexes making new all time highs any time soon is remote at best. I believe these rally waves are merely part of a very large corrective pattern, as follows. The move down from 2000 is the first of 3 major waves. The 2nd of these major waves was counter-trend that begin in October, 2002. Within this 2nd major wave will be 3 waves of an intermediate degree. The first of these 3 intermediate waves is shown in the current charts as a 5 wave rally from October, 2002 to now. This should be followed by a large corrective pattern (which should also be comprised of 3 minor waves) and then another 5 wave rally after that - to complete the 2nd major wave. The third major wave would eventually take S&P 500 and Nasdaq down to their new lowest lows in the 2011-2014 timeframe. The following chart roughly diagrams this scenario. Note: Although this Nasdaq chart appears to go negative with the green "C" wave, actually I expect it to end below 1000 and probably somewhere around 500. The S&P 500 should exhibit a similar chart pattern.

3) The final scenario may be unlikely, in my opinion, but retains worthy consideration until proven wrong. This scenario is where all significant stock indexes had major peaks in 2000, or thereabout, and exhibited a significant correction into late-2002. From there, all stock indexes are rallying toward new all-time highs - with Russell 2000 leading the charge. This means that eventually DJIA, S&P500, and Nasdaq should make new highs... eventually. Long time CyclePro readers are aware of the many reasons why I dislike this scenario along with the many reasons to support my stance. However, within a highly inflationary period, such as one that I believe we may be entering, it is entirely feasible that all major assets may appreciate in price. Notice I said price, not necessarily appreciate in value. When looking at only the raw index levels, only the price of the component stocks are taken into consideration. With sufficient currency inflation, all of these indexes could continue rallying even though their core values actually decrease. This is the basis of my 200-year inflation adjusted DJIA chart - I still hold to my original forecast of the DJIA trading well below 5000 and likely down to the 3000 area, all after adjusting for inflation.

Gold Stocks have been going through a little turmoil recently even though the price of gold has been rising. A lot of the upset has been caused by mergers and acquisition within the gold mining & exploration companies. This is expected in the life of a major bull market as industry visionaries look for ways to increase capitalization, reserves, and decrease competition before the bull ernestly begins to take off. But stockholders are savvy enough to recognize the difference between a good merger and a bad one... and embattled takeover fights do little to consolidate support. I recognize the need and desire for mergers, but what we have been seeing over the past year has been little more than petty infighting and not at all productive. In most cases the stock price has been battered down, unnecessarily. In S. African companies for example, their depressing stock prices reflect not only corporate indigestion but also international currency exchange variances.

Looking forward for 2005 and beyond for gold bulls it is important to hold physical gold. If you want to hold stocks, chose the highest quality companies. Even when speculating with junior companies, it is most desirable to hold a diversified mix of only the stronger candidates. It is still not too late to reassess portfolios to weed out not only poor performers, but also companies whose corporate outlook has changed since when the stocks were originally purchased.

The last time I made a significant change to my portfolio structure was 2 years ago when I reduced (and subsequently sold out of) my exposure in DROOY. Their corporate project plans changed and I did not like where I thought they were heading. This was when the stock was $3.60, now it is around $1.50. DROOY started 2004 at just above $4 and teh price chart shows that the highs have been progressively dropping along a smooth slope all the way to now. I bring this up only because several readers have asked for my opinion recently... I did not like their outlook 2 years ago and I do not like it now. My opinion could change, but only after I see a significant change in their corporate leadership. As for the price chart, I believe buying DROOY now would be akin to juggling with knives and is better left with short-term trading adrenaline junkies. I will not even consider looking at DROOY until the stock price exhibits a significant breakout of the downward sloping trendline.

I still like Golden Star (GSS) and Wheaton River (WHT) even though their charts have been hampered by unproductive merger dealing.

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