What works in deflation or mild deflation?

[ERICOPOLY]

Fairfax's deflation bet is pretty small (as percentage of equity) compared to their previous CDS bet (which was something like 10% of equity).  This despite the fact that the CPI contracts are 10 yrs duration vs 5 yrs duration for the CDS.  They are worried about their equity prices however, clearly.  I think the first 25% drop in the Russell 2000 will get them back to about the point where they bought those hedges... and I think the index traded down to a point 30% below current levels last year, and they didn't close them out at those levels.

 

[ERICOPOLY]

Then there are the people who say that companies have boosted their profit margins by cutting labor costs, and that the trend must revert to the mean.  That wouldn't be deflationary, but it would hurt some equities (not the banks or home builders).

 

EDIT:  Here is the link to "The Invisible Stock Bubble":

http://www.smartmoney.com/invest/stocks/the-invisible-stock-bubble-1305647031991/?cid=sm_dailyfinanceRSS

 

Of course, if incomes are temporarily depressed doesn't that mean that the personal debt bubble isn't as big as people say?

 

[goldfinger]

"Levels of debt seem still pretty high to think that a bit more is in the card at least"

 

There's nothing like inflation to melt away debt and make debt ratios look miniscule. Suppose I have $100 debt and $200 of hard assets, my debt to asset ratio is 50%. But now inflation kicks in and my hard assets are worth $400 but my debt is still $100 , my debt to asset ratio is 25%. There is no such thing as too much debt in an inflationary campaign, it all goes away like magic!

 

Agreed! Where is inflation at this point however? Everyone talks about it but I can't see it in the numbers (I agree that it depends on how you count it).

To me you need to have continuous money printing exceeding deflationary trends/money-credit destruction, wage inflation accompanied by spending/velocity/credit increase or a combination of both in the long run to get to inflation.

[goldfinger]

Then there are the people who say that companies have boosted their profit margins by cutting labor costs, and that the trend must revert to the mean.  That wouldn't be deflationary, but it would hurt some equities (not the banks or home builders).

 

EDIT:  Here is the link to "The Invisible Stock Bubble":

http://www.smartmoney.com/invest/stocks/the-invisible-stock-bubble-1305647031991/?cid=sm_dailyfinanceRSS

 

Of course, if incomes are temporarily depressed doesn't that mean that the personal debt bubble isn't as big as people say?

 

 

May be a lot more profit/revenue is generated by:

- laying off here and hiring in emerging nations.

- doing business with/in emerging nations (they are the growth engine at this point).

If that's the case we need to understand the consequences of:

- a major recession hitting emerging nations (China in particular).

- currency readjustments. China cannot afford the peg anymore...

[ERICOPOLY]

"Levels of debt seem still pretty high to think that a bit more is in the card at least"

 

There's nothing like inflation to melt away debt and make debt ratios look miniscule. Suppose I have $100 debt and $200 of hard assets, my debt to asset ratio is 50%. But now inflation kicks in and my hard assets are worth $400 but my debt is still $100 , my debt to asset ratio is 25%. There is no such thing as too much debt in an inflationary campaign, it all goes away like magic!

 

Agreed! Where is inflation at this point however? Everyone talks about it but I can't see it in the numbers (I agree that it depends on how you count it).

To me you need to have continuous money printing exceeding deflationary trends/money-credit destruction, wage inflation accompanied by spending/velocity/credit increase or a combination of both in the long run to get to inflation.

 

One more thing that could produce the most significant form (house price) of asset inflation:

 

Building them slower than growing demand.  Are we building them slowly?  Granted, hasn't yet led to anything but price declines, however we all concede that we started with too many.  What happens to prices when we have too few?

 

I'll wager that a significant portion of that personal debt per capita is at least partially if not substantially backed by real estate.

[ERICOPOLY]

If that's the case we need to understand the consequences of:

- a major recession hitting emerging nations (China in particular).

- currency readjustments. China cannot afford the peg anymore...

 

Are we going to see a rebirth in US labor and manufacturing if China cannot afford it's currency peg anymore?  Or will it just go to some other low cost nation, perhaps with labor that already cheaper than China's at the present.

[Vish_ram]

The way i viewed it was like bond YTM, you are reinvesting the coupons and in the end YTM equals inflation. The article talks about zero return on owned home and not rentals.

 

But if i got an asset that throws off free cash and asset value goes up in only nominal terms, then its not a bad deal.

 

 

There was another post that said, the real return on housing is practically zero. that means given some inflation ,what ever home price appreciation we got is purely in nominal terms. Now if you are going to have deflation, home prices are sure to drop even more.

 

 

You are ignoring the value of the cash flow.  I guess a utility yielding 14% is not worth purchasing if the price gains are merely nominal?  I mean, that's really the issue here.  You are asserting that real estate is poor investment but not discussing the fundamentals.  Just speculating on price movement.

[ubuy2wron]

NOBODY is building any new housing of any consequence and millions of more families are about to get foreclosed  many will have to become renters.

 

The moment that happens they'll just rent the unit that is being sold.

 

These rents are far lower than the mortgage they were trying to pay.

 

Surprises me that people aren't noticing that foreclosures simply mean people with extra money to spend on consumption.  Except for the squatters that got 18+ months of sitting in the home without making payments of course.  But generally speaking, the rents are nowhere near the 2006 level of mortgage payments.

 

It seems to me like the prior rent level must have been artificially low, due to the oversupply of housing during the construction boom (people who should have remained renters bought new homes, artificially depressing rents).  Now the opposite situation over the next few years if construction remains depressed -- a housing shorting, artificially boosting rents. 

 

Of course, people argued that over supply was the main impetus behind the housing collapse, but refuse to accept that a supply shortage is looming.  They want to instead point out that Japan house prices just kept going lower, despite their population of home dwellers doing the same (which doesn't seem to matter to these bears, for whatever reason supply/demand isn't in vogue).

That is exactly what is happening they are not renting the home they were in they are renting the home across the street. The bank will not allow the owner to become a renter in a short sale and the mkt is now rapidly being dominated by short sales instead of foreclosures. The price of these homes have fallen by 60 percent the buyer who has good credit can rent for a price of less than 1/2 the previous owners mortgage payment and generate a positive cash flow. The winners are the owner and the renter the losers are the US taxpayer and the banks or who ever held the original mortg.

[goldfinger]

Are we going to see a rebirth in US labor and manufacturing if China cannot afford it's currency peg anymore?  Or will it just go to some other low cost nation, perhaps with labor that already cheaper than China's at the present.

 

Possibly both!

[ERICOPOLY]

The article talks about zero return on owned home and not rentals.

 

The returns are higher on owned homes vs rentals, because you don't have to pay tax on the implied rent you are earning.

 

Everybody has to live somewhere -- owners pay rent... it's implicit.  It's the rent they would otherwise be earning if they moved out and rented it... but then they'd have to pay rent themselves to live elsewhere.  Back it up a step so they don't move out and live elsewhere, and one can see what is going on -- both your own landlord and tenant.

 

This is why owning a home is the best investment most people will ever make.  Hardly anyone can find another investment that would dependably throw off enough after-tax income to pay their rent, and 100% adjusting in lock step when rates rise.

 

But it's not in vogue to call it an investment.

 

Yes, you can stupidly take on too much mortgage, but you can also stupidly rent a place beyond your means that leaves you with no money left for savings.  So that's a wash.

[Myth465]

I think living somewhere should be totally separated from investing. There are so many variables its hard to quantify. With that said in a typical environment with fairly priced housing I agree with Ericopoly and Buffett (he believes it a highly levered short on the USD, as well as a way to save for the typical person).

 

I think when we discuss investing in housing, we should do so in the non owner occupied space.

[oec2000]

Just a quick question, how will the FED control interest rate once QE2 goes away? Won't they have to sell those securities too one day?

 

BeerBaron

 

They can hold to maturity while funding with low short term rates. The Fed controls short term rates simply by setting them through the Fed funds and discount rates. Traditionally, the Fed has no control over long term rates - the QEs were an attempt to bring long term rates down, so far unsuccessfully.

[oec2000]

If I have $300,000 of mortgage debt and my house is underwater by $100,000... and I walk away from the house, isn't that delevering?  I can still go out and spend like I always did... nay, I can spend more because renting is cheaper..

 

And supposing the MBS that carries my mortgage is already discounted in the market place by that $100,000... then what happens to the economy?  I walk away and the value of the MBS doesn't change, but now I spend more?

 

I realize that this doesn't explain the entire picture, I'm just wondering if we've already deleveraged at least a good portion of that consumer debt... this due to so many of them trading in the marketplace in these bundled securities, and at least substantially discounted by the market.

 

It depends on how much of the debt is non-recourse. Also, are things like HELOCs non-recourse? Going forward, the strength of consumer spending depends on where personal savings rates stabilise. Current rates are still below historical norms, I think. Also, employment and personal income levels are dependent on what happens to govt stimulus spending.

 

Interest rate levels are also a factor to consider. The burden of debt is a function of the amount of debt AND interest rates - it is no good if the former drops and the latter rises. How much of the foreclosed debt were teaser rate loans that have been replaced by lower debts but which pay higher rates?

 

The discounting of debt securities by the markets do nothing to ease the burden of debt servicing.

[Sea Island]

I aksed Brian Bradstreet this question at the AGM, he recommended 30 year zero coupon treasuries as a deflation hedge.  He answered without hesitation. He did not say real estate. He also said when asked what is something that we Fairfarx would never own: a brick of gold.

 

As far as the real estate question, during the Depression in the U.S., rents were simply uncollectable and judgements were useless. People do have to live somewhere but they dont have to live there alone. You can fit quite a few families in the average size U.S. house. You will know when its time to look at housing when the owners are tearing down houses/buildings to avoid having to pay real estate taxes. This is what happended to owners without mortgages in the 1930s; those with mortgages just left and lived on the street(gov. housing) or moved in with family. Because of the expenses(taxes, utilities, maintenance) primary residences are a horrible "investment".

[Packer16]

I think the other area is restructured real estate (like what KW is doing).  Another question I asked Brian is why they did not have deflation swaps on the yen and he stated they were too expensive.  So the US and Euro swaps were in part bought becasue they were cheap and there was no expectation of deflation.

 

Packer

[ERICOPOLY]

He also said when asked what is something that we Fairfarx would never own: a brick of gold.

 

Prem once said "we do not invest in gold" on a conference call -- was somewhere in the 2007-2009 time frame.

 

[ERICOPOLY]

As far as the real estate question, during the Depression in the U.S., rents were simply uncollectable and judgements were useless. People do have to live somewhere but they dont have to live there alone. You can fit quite a few families in the average size U.S. house. You will know when its time to look at housing when the owners are tearing down houses/buildings to avoid having to pay real estate taxes. This is what happended to owners without mortgages in the 1930s; those with mortgages just left and lived on the street(gov. housing) or moved in with family. Because of the expenses(taxes, utilities, maintenance) primary residences are a horrible "investment".

 

Now, if we use the Depression as a yardstick to measure any "investment", then we might also use Weimar Germany too.  Thus even the zero coupon bonds are a terrible investment.

 

The question on the thread wasn't about whether or not a Depression was coming, it was about mild deflation or deflation.

 

Perhaps this is a question about what to buy for the 1920s, a period of mild deflation.  Or Japan -- had you bought real estate in Japan with cap rate north of 10% you'd be doing fine today.  The trouble is, cap rates in Japan weren't at 10% in 1989 which is why the price fell.

 

Like all things, it's best to buy when price to cash flow is well and truly out of whack with the median levels.

 

It doesn't surprise me at all that the Fairfax officers didn't mention real estate as a good investment right now -- it's completely below their radar to be buying $60,000 houses for rentals.  You might as well ask Buffett which microcap stocks he's considering for Berkshire's portfolio of stocks.

 

EDIT: Actually, were it not for the government intervention in 2008 Berkshire would already be bankrupt by now.  So that's not a good investment either.

[oec2000]

I aksed Brian Bradstreet this question at the AGM, he recommended 30 year zero coupon treasuries as a deflation hedge.  He answered without hesitation. He did not say real estate. He also said when asked what is something that we Fairfarx would never own: a brick of gold.

 

 

I am not sure what this proves other than the fact that FFH missed out on the massive bull market in gold. In any case, this may not be the consensus view at HWIC - a HWIC principal I spoke to at AGM mentioned (in passing) owning physical gold personally. While I agree that it pays to be aware what the smart investors are doing, this is no substitute for making our own decisions based on all the facts and arguments we can assemble.

 

The strongest arguments against owning gold are its significantly lower cost of production vs price and the impossibility of determining its intrinsic value. On the other hand, gold has many smart proponents who consider it the best currency to own during periods of financial dislocation. All of us have exposure to at least one currency even though we can't compute its intrinsic value. For most people, it is almost like choosing a religion - they choose the one that they are most familiar with growing up.

 

As for real estate, FFH's investment in Kennedy-Wilson is a bet on real estate. It may be wrong to read too much into FFH's deflation bet. It may not be that they are absolutely convinced we will see deflation; they may see it merely as a significant risk that is prudent to hedge against. They seem more convinced, however, that the indebtedness of the western countries will impose a major drag on their economies; hence, their bet on long term bonds which do not need actual deflation to do well.

[ERICOPOLY]

Also, are things like HELOCs non-recourse?

 

HELOCs are full recourse.  This is why every time somebody talks about Wells Fargo's underwater HELOC exposure I wonder why the same people don't make a big stink over credit card exposure.  After all, both are full recourse and neither is backed by an asset.  Why should underwater HELOCs be written down any more than credit card debt, given the same delinquency numbers (if the same)?

 

 

[Sea Island]

Now, if we use the Depression as a yardstick to measure any "investment", then we might also use Weimar Germany too.  Thus even the zero coupon bonds are a terrible investment.

 

The question on the thread wasn't about whether or not a Depression was coming, it was about mild deflation or deflation.

 

I was using the U.S. Depression of th 1930s as one example of why a person's home can be a poor investment for the home owner and for the bank. Obviously you could also look at the past 5 years any number of markets to see the destruction of wealth through residential real estate. Regarding Brian Bradstreet, I asked him what he would do as an individual investor to handle deflation; we know what Fairfax has done on an institutional level. His comments about gold where in the public meeting and I believe he was speaking on behalf of Fairfax so its quite possible that he goes home and swims Scrooge McDuck style in a pile of Krugerrands.

[ERICOPOLY]

Obviously you could also look at the past 5 years any number of markets to see the destruction of wealth through residential real estate.

 

That's not very instructive to use bubble prices for examples.  Every asset has been through a bubble -- all of them.  

 

How about buying FFH at it's valuation peak in the late 1990s?  Does that lead to any meaningful conclusion as to it's merits as an investment today? It traded on April 14, 1998 -- for $600 CDN.  Today, 13 years later, you're still left wondering how much longer you need to hold it just to get back to break even.

 

Had somebody bought at 10% cap rate at the top of the real estate market in 2006 they would have largely already recovered any lost "wealth" through cash flow.  The trouble of course is that real estate deals with 10% cap rates were not available in 2006.

 

 

 

 

[Sea Island]

Eric are you referring to residential real estate and assuming cash flow is rent that you would otherwise pay which you aren't?

[ERICOPOLY]

Eric are you referring to residential real estate and assuming cash flow is rent that you would otherwise pay which you aren't?

 

I'm saying that if you get cap rates of 10% today, then it's a good investment.  This is way above the long term mean, so it's a value investment.

 

Doesn't matter to me whether you live in it yourself or rent it out.