Its Dues Paying Time: American Myths Being Destroyed — And What May Happen Next
by Carl Haefling
This piece is one I promised a number of folks as I received emails while traveling and upon my return learned that my doom and gloom predictions had become reality. Over the past 3 or 4 years I have written extensively about the systemic issues regarding real estate. I have believed, since Greenspan lowered interest rates following 9/11 in an effort to prevent a recession, that the unintended consequence of over stimulating the real estate markets would have dramatic consequences. My intention here is to reflect about my life long experience in the stock market, how that experience shapes me today, and my belief about what possibilities lie in front of us.
However, before going further let me make a few upfront statements. I am not an economist; I have never been paid as a stock analyst nor to run a hedge fund or mutual fund. When I was 42 I took a very small brokerage business and turned it into a money management business giving me full discretion over the clients’ assets in the account. I began with about $3m in assets and turned it into $120m without adding additional funds in about 13 years. I had an annualized return of over 40% a year and then decided to quit. Enough was enough, and from my perspective the signs were clear that it was about to get ugly. I had learned that though I was successfully managing other’s people money, the stresses and responsibilities were high. As I created money, I was changing the course of people’s lives, including my own.
As the size of the assets under my management increased, my staff did not. It was me, me and more of me. I was licensed with a firm in Cleveland who executed my transactions and held the securities, but I did all of the work including answering the phone.
My success was really the result of my ability to recognize patterns that repeat themselves, learning how to take advantage of those observations, and not assuming that I knew more than the market. I had become interested in the stock market when I was about 13 years old. I read everything that I could lay my hands on. My Bible for understanding what was happening in the markets at that time was Joseph Granville’s book “A Strategy of Daily Stock Market Timing For Maximum Profit.” I still believe that in terms of how I see markets, it has been far more helpful than anything I have read since, with the exception of “Technical Analysis of Stock Trends” by Edwards and Magee. I discovered this book a year or so after reading Granville’s and for the most part they have been the most useful in helping me understand more clearly what I was noticing. In the 1960’s and 70’s technical analysis was for the most part considered voodoo. Charts and information being tracked had to be posted by hand. Now technical analysis is in vogue with very sophisticated computer programs that can do everything and beyond what a chartist thought possible when Edwards and Magee first wrote their book in 1948, the year I was born.
When I was 14, I decided to buy my first stock. I went to the library and started doing research. I had a relatively simple theory. If it had gone down significantly, it could go up significantly. The first thing I did was find a few stocks on the NYSE that dropped from a very lofty level to a very low level. The one I settled on was Control Data. It had dropped from 120 to around 10. I identified what I thought to be the reason; it was really pretty simple. They were one of the leading companies developing super computers and they had run into technical problems that delayed their ability to commercially launch their product. So I bought it around $12 a share and became very lucky—a year later it was $120 and my $120 became $1200. It was almost instant gratification. Ultimately what I had to figure out was what really made Control Data skyrocket. I did not fully understand it until I was about 42 years old. I sold CDA near its high of $120, for the simple reason that if it had gone from $10 to $120 it could go back to $10. Eventually it did, and for most part eventually disappeared. I did not stop with CDA, and by the time I graduated from high school my $100 became $10,000. I went to college, and my $10,000 became worth about $100. What I discovered in college was how to lose money.
In going to college I really did not have a clear vision of what I wanted to study, other than knowing that I was interested in the stock market. I started with a finance major and by the end of my sophomore year decided that finance had little to do with knowing why stocks went up and down. I changed my major to education and started taking courses in the philosophy of education, behavioral sciences and other areas that looked at communication skills, how groups function, counseling and therapy skills, and organizational consulting. I eventually finished my college career with a Master’s degree having studied counseling models and organizational development. I had discovered that one of my most significant talents is noticing human behavior, understanding theories of behavior and seeing how they fit into my life experience. I also discovered that the hardest thing to understand and change was my own decision making process and how I repeated some patterns that were both helpful and destructive. Ultimately when I encountered the Myers Briggs Inventory,it fully dawned on me how my own behavioral preferences influenced how I make decisions, manage and use data, and how all of this was impacting my ability to be “consistently” successful in the stock market.
It was from those studies that I began to learn about systems thinking, human behavior in group settings, power and influence, decision making and other areas, all of which manifest in how people make decisions about trading and investing in the stock market. I learned tremendously about my own process and what enhanced or reduced the chances of success. I also discovered that I had talents that could be used professionally outside of the investment world as a counselor or organizational development consultant. It was only when I turned 44 that I decided to fully commit myself to the stock market. I had spent enough time getting to know myself—it was time to find out if I knew myself well enough to try and create wealth using what I had learned about human behavior, systems thinking and how that is reflected in the stock market.
One of the tools I began using about 15 years ago was creating various scenarios about what would happen in the markets that would lead it down, sideways or up. I would create a series of expectations for each possibility and then wait and see which unfolded. I never claim to know what is going to happen, but I would assign probabilities and create benchmarks that suggested one scenario or another was unfolding. I did the same with individual stock selection. My focus however was wealth creation, not wealth protection. Most large investors want their wealth protected and are also still greedy enough to want to produce more wealth. I was not rich and neither were my clients. For me the only reason to be in the stock market was to create wealth, not protect it.
Over the years I would communicate primarily once a year with my clients in writing. In that letter I would outline what happened in the previous year and outline what I thought were macro issues for the coming year. In about 2004 and 2005 I became concerned with how real estate prices were inflating, that homes were being sold based on future appreciation vs. more traditional standards of significant down-payments, and that homes were not purchased for quality of life issues but rather to provide personal ATM with a line of credit. It takes time for irrational exuberance to completely unfold. In the stock market there are pretty clear signs that the end of a bubble is near. I continued to believe that beginning in about 2006 the real estate bubble was ready to unwind, but I also believed it would happen more slowly than it has with the real massive decline taking place between 2009 and 2012. My time frame could theoretically still be true for future declines, although I believe there is a small possibility that the worst will be over by the end 2009 or 2010. The real question is not whether they will stop going down (they will), but whether real estate values will go back up? I don’t believe they will for a significant amount of time. Residential real estate has been and will remain the canary in the mine as long it is perceived as a means to create wealth vs. improving quality of life.
As we all now know, real estate prices have for the most part collapsed. I have one idea for increasing demand for foreclosed homes that have declined 50% or more in value. Fannie and Freddie should make available loans with 1 to 5% down, only for “foreclosed” homes that have declined in value by a very significant percentage from their previous sale price. This may increase demand for foreclosures, reducing inventories. I know this sounds like lighting the same fire over again, but I do not believe that will be the case. The key is preventing the commercial banks and others from making loans that do not require a down payment of 10% or more and using loan qualification factors that worked between 1945 and 2002, when the cost of money began to make it possible for zero down or interest only home mortgages. This article is representative of a stable local real estate market. Note the reference to homes being bought with payments that would be similar to a rent payment.
One of the problems created in the sub-prime markets was competition. When builders and banks began funding subprime loans, the markets became flooded with inexpensive new homes and houses in run down neighborhoods suddenly started increasing in value. The low cost of interest at the Fed and the flooding of the economy with dollars made this opportunity available. If you want to create deflation, in this case the decline in home values, just dramatically increase supply when demand remains relatively constant. In 2004 and 2005, if I remember correctly, one out of two homes that were being purchased were second homes. Many were meant to be flipped, held for a short period of time and resold because of market appreciation. There were TV shows about individuals doing this. It created artificial demand, people buying homes only with the intent of reselling, and in reality the number of buyers were actually decreasing with time. Think about it: if one out of two homes being sold is a second home, what is going to happen when buyers quit buying second homes for economic reasons or simple common sense?
Now the Fed has been intent on creating capital for the banking system. This slows down the process of the destruction of the banking system but it does not solve the problem that helped create this mess, simple oversupply of homes for sale. Banks are fearful of lending, but not in places like the Lake of Ozarks in Arkansas. Most likely the reason is that the rationale for lending is based upon existing values and cash flow, not anticipated value and cash flow. For a short period of time I owned some commercial properties when I was in my 30’s. The reason I bought a property was based upon rental cash flow and its ability to cover a mortgage in 7 years, hopefully even less. I had no intent of making money from appreciation, but wanted to make it from cash flow. If you are using rental income to pay off a home, eventually you will own it with your cost only being time and the aggravation of being a landlord. I decided I did not like being a landlord so I sold the properties a few years after owning them.
The remaining problem is the flood of homes that is constantly coming into the market to be sold. Increasing the capital at banks and saving them from ruin in the short run will not solve this problem. The government rescue plan may provide a breather giving remaining banks a chance to stay in business, but it is not going to reduce the supply of homes for sale. Ultimately, if the supply problem is not solved, real estate prices will continue to drift down, maybe less dramatically, but down as supply continues to run ahead of demand. The only way to solve this problem is to make it easier for lower priced homes to be sold that have dropped to levels where the cost of renting it would be the same as making a mortgage payment. Until then, the numbers simply do not work for home ownership since the belief that a home may appreciate in value has been completely lost, at least for the next 10 years if the Great Depression is any indicator of the future of home prices. If you allow the market to do its work it will continue to destroy home value, neighborhoods, and generally financially wreck the lives of more and more people. Those who worship the God of the free market economy ultimately believe equally in demand destruction and job and product creation. It is a delicate balance. If we look at the history of the economy in the U.S. there have been many healthy business models employing large numbers of people that only lasted for short periods of time because the demand for their product was ultimately destroyed by changes in consumption patterns, better and cheaper products, and other free market innovations. The free market functions its best, when it is relatively equally creating and taking away jobs that do not add value to the economy. At times the free market becomes lopsided. Right now the market is destroying jobs, home values and the banking system. What will it destroy next? Ultimately it will reverse the process of destruction and begin to create more than it destroys. But that is no comfort to all of those who are being terribly harmed financially and emotionally in this cycle. Theoretically, banks and brokerage firms that were gradually shredding the regulations (even though regulations were not being enforced under the Bush Administration), have themselves been destroyed as the market signaled that selling subprime loans will not work any longer because supply has overwhelmed demand. People suddenly realized that the market had become saturated. Brokerage firms and banks that earned big money on fees and sales commissions quickly went out of business as the buyer side of the market evaporated.
In the case of home ownership, we are still facing the dilemma of a declining number of buyers and an increasing number of sellers. There are more than one or two forces at work. The obvious one is demand destruction. Real estate became too highly priced in too short a period of time. This created the illusion of wealth through home ownership at a time when national demographics suggest that the number of homes needing to be sold from about 2008 forward is going to increase as the average age of our population increases. The largest segment of U.S. citizens are baby boomers, and many had been planning on selling their homes to create cash to help support their retirement. With the home market becoming more illiquid and declining in value, they are now faced with liquidating any other asset they have, possibly prematurely. There are many, many stories now being seen of folks who worked for Wachovia, Washington Mutual, Countrywide or many others who lost not only their retirement accounts concentrated with stock that had declined 90% or more in value, but homes that have also declined in value.
In the U.S. we have lived believing in a number of myths about our economy. One of those myths was that home prices will go up forever. There are other myths, like anyone who works hard will be rewarded with a pot filled with high priced stock for retirement, (just ask anyone employed at just about any bank in the U.S., G.M, Ford, or who used to work for Worldcom or Enron if that is true). Another is that you will be able to live the same quality of life retired with the same or similar income that you had when working. A less well known myth is that even though we only have 4% of the world’s population we can continue to consume over 20% of the world’s resources without ultimately generating more and more competition for that 20%. The past couple of years should be known as “myth busting time”. The hard lesson learned, and this seems to keep repeating itself, is that in a Capitalistic economy if there is a good idea that creates wealth quickly, it will be identified, copied and mass created until it creates failure. We have seen that happen over and over in the financial markets and with corporations who are successful for a period of time and almost inevitably fail. Demand destruction has effectively ruined Bear Stearns, Lehman Brothers, hundreds if not thousands of mortgage companies, and forced banks and related businesses into merger or bankruptcy. More and more companies will go out of business, the unemployment levels will expand, and there is little that Obama or McCain can do about it. The decisions made by the Bush Administration and the Fed have drastically reduced our choices in funding our financial obligations and the various programs that our citizens have become accustomed to.
It is now dues paying time.
Many of the corporate goliaths of the past in the U.S. are a fraction of what they were 20 years ago including G.M., Ford, Chrysler, Eastman Kodak, and many, many others. Will the U.S. be a fraction of what it was in global consumption in the next 20 years? Most likely the answer is yes. China, India, Brazil and others have turned to systems that are in many ways modeled upon market driven economies. For the first time in the economic history of the U.S. we really do have other countries that are fully competitive for the same resources that the U.S. has needed to fuel its economy. The Democrats, who seem to have a need to return to protectionist polices, will seal the doom of the American economy if we attempt to protect ourselves against the competitive drives of other nations. The United States is following the economic path of Great Britain in 1900 as it began the transition from being the most powerful economic force in the world to one of the has been economies of the world.
In the past year and a half we have witnessed the demand destruction cycle that is a significant part of the market economy in action. Deregulating the financial system had the exact opposite impact than what was intended. It destroyed jobs, destroyed wealth, and is destroying our financial system. Human behavior needs to be regulated. The financial system is no different than other systems where criminal, immoral or unethical behavior takes place. The market system ultimately takes advantage of the less informed, the weakest and those that care. It is a soulless mechanism that allows for survival of the fittest. We have repeatedly seen how markets melt down as financial power becomes more concentrated and those who care more about the religion of free markets dominate those who care only about a decent quality of life.
The free market system is only balanced if it anticipates its own destruction. It can only do that with rules and regulations that attempt to prevent the manipulation, or assumption of risk that dramatically enhances the chances of self destruction. Human behavior has demonstrated that many people will simply attempt to use a system to their own advantage, taking down everyone with them if they fail, and leaving everyone standing below them if they have some degree of success. Left to its own devices, the free market system is a slice and dice approach to economics that ultimately leaves a survivor or a few survivors standing. People smoke until they die, overeat until they die and they will practice thoughtless and reckless financial decision making until they run out of money. That does not mean, however, that someone who works in the same office as a smoker should develop cancer from second hand smoke, or even that health insurance should pay the bills of someone consuming 5000 calories a day or more, or that an employee of a bank should not lose their retirement because of a small number of executives interested in enhancing the value of their stock options.
Libertarians for the most part believe that the higher nature of humanity will surface and ultimately allow for a free market to prevail. I believe that is naive at best. Conservatives historically taught the value of conserving. But in government the Republicans have demonstrated over and over that while claiming to save, they are bigger spenders than any administration since Johnson. Democrats also love to spend, but for the type of projects that the Republicans typically dislike, even despise. Democrats also have a history of over-taxation and abusing financial common sense with pork barrel spending. Republicans also love pork barrel!!! Republicans took advantage of over-taxation and made it a campaign issue over the years, playing to individuals who believe that tax cuts are a good thing. This can be taken to the extreme, as Palin’s comments represent when she said, “I believe that paying taxes is un-American.” The real problem being faced by the U.S. right now is that all political parties have co-created levels of government debt that can only be reversed by higher income streams and lower spending levels. I believe this country has one choice—cut spending primarily in the military and health care and increase revenue streams or we face one of two economies with massive deflation or massive inflation. Both will decimate our way of life and national pride. Our inherent greed and attempts to pay for wars, homeland security, and health care needs of our aging population, without increasing our revenue streams, will destroy our way of life. Instead of having something, we will have very little. What remains to be seen is whether it will be deflation or inflation that brings our treasury to its knees with nowhere to go. The Republicans have attempted to convince the public that lower taxes actually lead to higher income streams. This is only true if the economy continues to grow in leaps and bounds and the capital gains in the stock market explode. There are arguments on both sides of the trickle down theory, but I think it is pretty obvious by what has happened since 9/11 that decreasing taxes and exploding spending (forgive the military metaphor) is a very quick path to a severe recession if not worse. Trickle down may work in the brief periods of time when we are near full employment, but those do not last primarily because the free market will ultimately attempt to exploit what created full employment and lead us into a cycle of demand and job destruction.
There is also a third hopeful possibility. However there are virtually no signs that it has a chance of happening. There are those who believe that the American economy will once again find a way of resurrecting itself, the problems will go away, the economy will gradually improve and all will go back to being normal. They believe in the power of creativity, entrepreneurship, and that real estate prices will return to 2004 levels. I certainly prefer that outcome, but there are still too many problems to be faced. For the life of me, I do not understand how the U.S. can maintain its economic leadership following the financial body blows of the last year and a half with more coming down the road.
Let’s create a list that is by no means complete, but is representative of future problems, that are not in the distant future, but rather the near future.
1) Next year commercial real estate prices could shatter, bankrupting most REIT’s and leading to another series of massive write-offs in the lending sector.
2) The complete restructuring of the credit card industry may be in the future. Credit card delinquencies are 4.8% and rising monthly. What is the tipping point for the industry? When will banks become fearful of the losses from credit card defaults? When will credit card issuers start demanding complete repayment, start systematically reducing the size of credit lines, and effectively stop issuing new cards to people with no credit history? It could become a pay as you go society similar to what existed before the invention of credit cards except for those with excellent credit ratings. What impact will this have on the last big banks left standing, including Wells Fargo, BAC, and Citi who have enormous credit card operations?
3) Auto loan delinquencies are approaching 4% and climbing. In some parts of the country lenders have quit financing the purchase of cars. The leasing of cars has already come to a grinding halt. The auto industry in the U.S. is on its last legs, just like the steel industry was 20 years ago, and other industries before it. What will be the impact on the economy if all 3 remaining U.S. producers end up in bankruptcy?
4) Mortgage delinquencies are now 5% and climbing. More prime mortgages are going into default and in 2009 another large number of ARM’s will reset to higher interest rates. Late next year there could be another round of foreclosures, this time among prime loan holders.
5) Speculative homebuilding by large builders is essentially over. Many are only being kept in business by the willingness of their banks. Only homes that are being built by the owner for the most part will be constructed. The job loss in construction will be enormous. Couple that with many commercial projects that will be completed in 2009, and by 2010 there will many jobs lost in construction and related industries.
6) Everything is systemic. We are interconnected and interdependent. Our inability to pay our national debt will ultimately force the collapse of various institutions similar to what we have seen happen with Fannie Mae, Freddie Mac, and other financial entitles. The inability to borrow money will create enormous problems for hospitals, utilities and other highly leveraged companies that are dependent on a healthy economy to create the cash flow to make debt payments. Utility and hospital companies have been historically dependent on their ability to roll over debt. Who did this for them? Wall St. and banks! Can they do it right now? Only at a high cost. Pennsylvania recently issued 20 year tax free bonds yield over 6%—the market is suggesting they may not be able to pay them off. How much will it cost a utility or hospital to refinance debt?
7) Dry bulk shipping rates have collapsed. Also, rumor has it, that those who use letters of credit to pay for shipments from China or anywhere are losing those credit lines. The end result will be shortages of product on Main Street and a drop off in our exports. A year ago the Bush Administration was pointing to exports as being a good thing. That will most likely end.
8) The U.S. dollar has rallied recently against most currencies. It has rallied for one reason, fear, and that is a terrible reason. The U.S. economy is not improving, quite the contrary. It is declining. The markets however for the short run believe the U.S. economy is in less worse shape than other economies. In the long run, I believe that will turn out not to be true. If the inflationary scenario becomes reality, the dollar will collapse going far lower than it did recently against other currencies as energy and metal prices skyrocket. Oil could easily go to $300 a barrel, as those holding dollars attempt to convert them into commodities. If you want to understand what happens when a currency is under-attack, read the recent stories on the failure of Iceland’s banking system. Just do a news search on the word “Iceland”. Do not think that it cannot happen here. If China, India, Brazil and others continue to strengthen their economies, become more efficient and are perceived by the market as more productive and successful, ultimately the speculators will focus on the weakest and that will be the United States. The easiest target will be shorting the dollar and the same impact will be witnessed as the destruction of Bear Stearns and others we have recently seen. In the securities industry the elimination of the uptick rule contributed enormously to the unraveling of stock values and volatility. In the currency markets there never has been an uptick rule. If you have the resources and are only concerned with winning, it will be relatively easy to short the dollar and as it drops, the shorts will short more as their leverage increases.
9) The non regulated derivative markets are always lurking in the background. Warren Buffet called them “financial weapons of mass destruction”. It is estimated that there is a $600 TRILLION market for derivatives that is totally not regulated. I am willing to hazard a guess and suggest that there are very few in the world who understand the hazards and the relationship of derivatives to all aspects of our financial system. If you want to have a little idea at what can happen if a small segment unravels, just take a look at the Lehman Brothers bankruptcy. They were a large player in the derivative market as was AIG. How many more bankruptcies with the trigger being derivatives maybe lurking out there?
I am sure there are other problems that will surface that I am not thinking of. If we have a highly deflationary or inflationary environment there are many characterizes of those that will impact life styles and jobs. Lets see which one emerges, hopefully it will be neither.
If you want to keep track of the data underlying the current economic development subscribe to John Mauldin’s newsletter, and read Barry Ritholtz’s blog, The Big Picture, which can be emailed to you daily. Both are free. They both do a great job, read far more than I do and are deeply connected in the investment community. I am not and really never have been. The web is loaded with good resources, many that are free. Pick a topic and do searches to see what you can find. Stay clear of mainstream economists who have a vested interest in outcomes. If they work for someone other than themselves, they are always aware of who writes the check that makes it possible for them to pay their bills.