Canada's Housing Bubble

Jul 21, 2010 Garth Turner GreaterFool.ca

Only a realtor would deny we’re on the cusp of something.

One like Ted Zaharko, who owns a Royal LePage franchise in Calgary (and was president of the real estate board). “We’ll get back into balance later this year,” he told the local daily as house sales crashed around him, “and maybe, maybe, by the first quarter of 2011, we’ll be in a sellers’ market.”

Actually, we won’t. By March or April of next year I wouldn’t be surprised if the real estate market is moribund, the economy flatlining and we’ve stopped talking about deflation because it’s a daily reality. There is now no denying that 2010 is shaping up to satisfying as a night with Michael Ignatieff. Or Betty White.

The journey to recovery, asset inflation and coursing interest rates has taken a detour, thanks to coddled Europeans (‘mort à l’austérité!’), uncertainty over China and (especially) serious setbacks for the US economy. Consumer sentiment has plunged because job creation has stalled, while unemployment benefits run out for millions. Reports this week will confirm the housing market is still crumbling and leading economic indicators have slipped.

In an economy now 70% fueled by consumer spending, the very fact a third of all homeowners are in negative equity means a double double could be close at hand. Without a doubt, that’s what the stock market has been saying – with the S&P 500 down more than 17% since its high water mark at the end of April. The bond market is also screaming this, as yields plunge on ten-year notes and prices rise (there is an inverse relationship between interest rates and bond values).

So, sadly, my recent forecast of asset deflation and price inflation looks increasingly likely. House prices tumble. Taxes increase. Recent homeowners in Toronto, Calgary, Edmonton and Vancouver start falling into negative equity. Governments get more broke. Furniture stores and framers suffer. And people sitting in equity mutual funds wonder what the hell happened.

There is no telling how long this might continue, but I’m thinking the real estate correction in Canada has a fine chance of lasting until 2015 or so – and maybe longer, thanks to the boomers. Because most of them have lousy investment portfolios, totally unbalanced and cobbled together by amateurs (them), and at the same time the bulk of their net worth is in devaluing houses, there’s no alternative but to alchemy real estate into cash as retirement looms. Most listings. Lower prices.

In fact, real estate alone has the potential to bring us years of deflation before the pendulum swings. This is the simple result of the recent bubble, which inflated prices and mortgages at the same time. But when house values (and wages) fall, mortgage debt does not – making debt tougher to repay and wiping out family net worth.

Want some proof? Try this. And the chart below shows a $4 trillion hit for the US middle class – the gulf between what they owe and what they now own. Do you think this cannot happen here?

Of course, there is hope. There’s even some time. And this is what I’ve been trying to make clear over the last couple of days.

This is the dilemma: Most Canadians don’t have enough wealth to get them through their lives. So, they desperately need to grow what they do have. Sticking it in the Dutch guy’s shorts ain’t an option. But at the same time, how do you invest when the stock market and the bond market are going in different directions, and volatility is the new black?

You get balance. First, make smart, careful choices to get growth from equities in a predictable way (through diversifying across geography, sectors and capitalization). Second, combine that with fixed income which feeds off deflation, plus assets that pay you to own them (capital gains and cash distributions). Third, you make damn sure you avoid taxes (through shelters, cap gains and dividends).

For example, my portfolio has 60% equity and 40% fixed income. So far this year the US market is down 4.3% and the TSX is off 2%. My stuff is up 2.2% plus giving me an annual yield of 3.5% (interest and dividends), or 1.8% year-to-date. So, the portfolio return has been 4%, or an annualized 8%.

How could that be? Because my equity investments are designed to give growth and reduce volatility, while the fixed income has torqued out capital gains as yields fall. In addition, the bonds and preferreds continue to pump income.

This is what investing’s about. As opposed to moaning.