Negative "Positive Feedback Loop" of Employment and Housing

[EJ]

Negative "Positive Feedback Loop" of Employment and Housing

Quick Comment - August 10, 2006

by Eric Janszen

I start my comment today with the following story:

Region feels ripples from home building slowdown
August 10, 2006 (Miami Herald Tribune)

Slowdown in building is rocking small contractors as they scramble for jobs

Southwest Florida's cooling housing market is starting to pinch people whose livelihoods are tied to housing.

Many workers like cabinet-maker Jorge Ayo face the difficult choice of leaving the region for greener pastures, doubling up on contracts or moving to other job sectors to find stable work.

Three months ago, Ayo says he earned $2,000 a week with one customer, Timberlake Cabinets. Now, even with two more accounts, he makes only half his previous income.

"Three months ago, I worked every day. Now the big houses are gone," he said. "I have a condo here and a town home there, and I get a few remodels here and there. And sometimes, I have no work."

Going back to January 2005, my piece on the seven step Housing Bubble Correction noted the high correlation of employment to housing prices.

Housing-related employment accounted for about 23 percent of the 4.9 million jobs created since the nation's job market began to grow in late 2003, according to Moody's, fueled by Fed policies designed to blunt the impact of the collapsing stock market bubble. A year earlier, in January 2004, I hypothesized that the housing market, when it starts its descent, will first "sieze up," for a period followed by falling prices and declining housing related employment -- in everything from mortgage lending, to construction, to agency services -- and that this decline in housing related employment will feed back into the real estate market as falling real estate prices. In electronics, this is called a "positive feedback loop," although there's nothing "positive" about it in an economic sense. I was certain of the process, the only questions were when would it begin and how rapid the decline might be.

The housing bubble peaked in mid 2005, about six months after my Housing Bubble Correction piece appeared on AlwaysOn-Network. The seven step model predicted that housing prices were not due to get hit by housing related unemployment until five years after the correction began. That means 2010. In retrospect, that prediction now looks very optimistic. Here we are one year into the decline and incomes and employment are falling fast in some areas. It's hard to imagine how even with a year or two of lag time, housing related unemployment will not begin to hit housing prices by, say, mid 2007 at the latest. That's three years ahead of schedule, per my original model.

iTulip.com has a rep as bearish but has been consistently optimistic in its predictions. In 1998, the site predicted an 87% decline in a basket of popular dot com stocks. If we remove the survivor bias -- leave in the companies that went out of business and therefor were deleted from the index but instead leave them in and account for them as zero value -- the decline was well over 90%. Also predicted in 1999, the NASDAQ was due to decline from 5000 to around 1500 and then rebound to 2500 and stay there for a decade. This, too, appears optimistic. It's traded sideways around 2000 for the past six years.

What does this mean for my housing correction prediction and the US economy?

Less than 25% of US households held a significant portion of their assets in stocks in 1999, so managing a crashing stock market bubble was relatively speaking a piece of cake for the Fed. But a housing bubble collapse can wreck an economy where 70% of household wealth is tied up in homes. I'm still wondering what the Fed has in its anti-deflation monetary repair plan to rescue us from the collapse of this latest asset bubble. It'd better be better than what Bernanke's hinted at so far.

Bernanke, in remarks before the New York Chapter of the National Association for Business Economics, New York, New York October 15, 2002, stated:

"My talk today will address a contentious issue, summarized by the following pair of questions: Can the Federal Reserve (or any central bank) reliably identify "bubbles" in the prices of some classes of assets, such as equities and real estate? And, if it can, what if anything should it do about them?"

He concludes:

"Understandably, as a society, we would like to find ways to mitigate the potential instabilities associated with asset-price booms and busts. Monetary policy is not a useful tool for achieving this objective, however. Even putting aside the great difficulty of identifying bubbles in asset prices, monetary policy cannot be directed finely enough to guide asset prices without risking severe collateral damage to the economy.

"A far better approach, I believe, is to use micro-level policies to reduce the incidence of bubbles and to protect the financial system against their effects. I have already mentioned a variety of possible measures, including supervisory action to ensure capital adequacy in the banking system, stress-testing of portfolios, increased transparency in accounting and disclosure practices, improved financial literacy, greater care in the process of financial liberalization, and a willingness to play the role of lender of last resort when needed. Although eliminating volatility from the economy and the financial markets will never be possible, we should be able to moderate it without sacrificing the enormous strengths of our free-market system."

Nice speech, but it's too late to use any of these prescriptions for the housing bubble, except for one.

We had a housing bubble from 2002 until mid 2005. Whether by intent or not, Fed rate hikes since 2004 collapsed it. As What (Really) Happened in 1995 points out, capital adequacy in the banking system is doubtful, although the Fed can likely fix that by throwing the discount window wide open, assuming the exposure that the banks have to hedge funds don't hit them at the same time. While the banks may have effectively stress-tested their portfolios and have adequate transparency in accounting and disclosure practices, many of the hedge funds that have borrowed hundreds of billions of dollars from them have not. Financial literacy in the US is poor, and anyway during the get-rich-quick frenzy of an asset bubble, common sense about finance goes out the window, even among experts, never mind Joe and Jane Sixpack. All that leaves us with from Ben's prescription kit is, "a willingness to play the role of lender of last resort when needed."

"We will not have a deflationary depression, dammit!" is the message from Bernanke in another speech in 2002.

New guy, but the same old "we can't do nutthin' about no asset bubbles" Fed. The Fed sees its role as that of a clean-up crew standing by to watch a train take the curve at 100MPH that was designed to be taken at 30MPH. They wait with fire hoses, the jaws of life, food, bottled water and body bags.

How will the Fed counter the massive deflationary impulse that the collapsing real estate bubble will unleash on the economy? Everything and anything to prevent the onset of a deflationary spiral. As Ben happily notes in the remarks quoted, unconstrained by the gold standard, the Fed can clearly re-liquify the system now in a way it could not in the 1930s. The Fed can print money and buy real estate directly. Maybe this period is what Bill Gross is referring to in his The End of History and the Last Bond Bull Market. Perhaps this is why Greenspan mysteriously recommended ARMs on February 23, 2004, when he spoke to the Credit Union National Association 2004 Governmental Affairs Conference, even though a 30 year fixed rate mortgage was then available at 5.5 percent with no points, at 40 year lows.

The "Ka" in Ka-Poom is coming. Gross believes it. Greenspan implied it. How do we play it? We know what's going to happen to real estate. What will happen to stocks, bonds, commodities and the dollar?

If previous episodes are any value as a guide, bond yields will fall and prices will rise and stocks will decline. The wild card is commodities and the dollar. They may decline as well, at least initially, but if dollar depreciation is used early and strongly enough as a measure to limit deflation, the downside on commodity prices, at least priced in dollars, may be limited and short lived.

Join our FREE Email Mailing List

Copyright © iTulip, Inc. 1998 - 2006 All Rights Reserved

All information provided "as is" for informational purposes only, not intended for trading purposes or advice. Nothing appearing on this website should be considered a recommendation to buy or to sell any security or related financial instrument. iTulip, Inc. is not liable for any informational errors, incompleteness, or delays, or for any actions taken in reliance on information contained herein. Full Disclaimer

[MLM]

Re: Negative "Positive Feedback Loop" of Employment and Housing

Eric, you are simply a bundle of joy. And so is Bill Gross -- he sounds like a guy who's planning on retiring about the time the "Poom" hits the fan.

While commodities may do well in dollar terms during a major/hyper inflation, the rest of of the world will be a mess, looking for someone else to buy the stuff they're manufacturing out of those commodities today. Foreign currency denominated bonds would seem to be a logical choice in that environment.

[jk]

Re: Negative "Positive Feedback Loop" of Employment and Housing

"supervisory action to ensure capital adequacy in the banking system" might mean a little something, someday. greenspan wouldn't hike margin requirements in 1996, which might have done some good. there have been some noises lately about cracking down on exotic mortgage products - unfortunately it's a little late on that barn door, too, but at least there was a gesture in the right direction.

you wrote: "Perhaps this is why Greenspan mysteriously recommended ARMs on February 23, 2004, when he spoke to the Credit Union National Association 2004 Governmental Affairs Conference, even though a 30 year fixed rate mortgage was then available at 5.5 percent with no points, at 40 year lows. The "Ka" in Ka-Poom is coming. Gross believes it. Greenspan implied it."
i think you give greenspan too much credit. [hah!] he later said that anyone who was still exposed to higher rates was clearly intent on losing money.

i am very much in agreement on your main line scenario, but am struggling about the short to intermediate fate of the dollar. look at the bounce in the dollar today! is that a flight to safety after the london airplane terrorist scare? if there is enough turmoil i could imagine the dollar benefitting for a while, because old habits die hard. that would fit with a bond rally, too. another contribution to dollar strength would be all the dollar shorts covering their positions to try to reduce their volatility.

so the dollar could strengthen throughout the ka phase as part of a short term deflation scare. i don't see how "dollar depreciation is used early and strongly enough as a measure to limit deflation," unless you mean concerted central bank interventions to drop the dollar. that seems unlikely. isn't dollar strength more likely during ka?

if so, then zero coupon treasuries NOW for ka, then foreign currency bonds LATER for poom. frankly, i don't know if i can pull off the timing.

[Spartacus]

Eric, are Gold and Silver still in your good books?

What do you make of Prechter's contention that in the great depression the only reason Gold and Silver held their price levels was because of government intervention?

Initially both Gold and Silver prices fell, until the US Federal Government put price floors on them.

[EJ]

Re: Negative "Positive Feedback Loop" of Employment and Housing

he (big Al) later said that anyone who was still exposed to higher rates was clearly intent on losing money.

i am very much in agreement on your main line scenario, but am struggling about the short to intermediate fate of the dollar. look at the bounce in the dollar today! is that a flight to safety after the london airplane terrorist scare? if there is enough turmoil i could imagine the dollar benefitting for a while, because old habits die hard. that would fit with a bond rally, too. another contribution to dollar strength would be all the dollar shorts covering their positions to try to reduce their volatility.

so the dollar could strengthen throughout the ka phase as part of a short term deflation scare. i don't see how "dollar depreciation is used early and strongly enough as a measure to limit deflation," unless you mean concerted central bank interventions to drop the dollar. that seems unlikely. isn't dollar strength more likely during ka?

if so, then zero coupon treasuries NOW for ka, then foreign currency bonds LATER for poom. frankly, i don't know if i can pull off the timing.

Great points.

"He (big Al) later said that anyone who was still exposed to higher rates was clearly intent on losing money."

At the time, Big Al was talking about short rates and to the boys in the yen carry trade.

"i am very much in agreement on your main line scenario, but am struggling about the short to intermediate fate of the dollar. look at the bounce in the dollar today! is that a flight to safety after the london airplane terrorist scare? if there is enough turmoil i could imagine the dollar benefitting for a while, because old habits die hard. that would fit with a bond rally, too. another contribution to dollar strength would be all the dollar shorts covering their positions to try to reduce their volatility."

Yes, the behavior is interesting. Stocks and the dollar up. How to correlate with the terror threat? Hmmm. We caught 'em, so relief? Gold dropped, but not much. What if they'd succeeded? No doubt stock market investors would have not been in a buying mood. But maybe the dollar would have rallied even more?

"So the dollar could strengthen throughout the ka phase as part of a short term deflation scare. i don't see how "dollar depreciation is used early and strongly enough as a measure to limit deflation," unless you mean concerted central bank interventions to drop the dollar. that seems unlikely. isn't dollar strength more likely during ka?"

Generally speaking, the "Ka" phase is the most dangerous time to hold leveraged assets and short the dollar. Keep in mind, the housing bubble is a global phenomenon. Initially, after the stock market bubble popped, and remember it too was a global bubble, we hit bottom in deflation and PM prices in 2001. Every major central bank was pumping away at the same time, with PMs all rising steadily, even after they stopped in 2004. It's never the same twice, but elements of this mini-Ka-Poom will happen in an exaggerated version in this cycle.

"If so, then zero coupon treasuries NOW for ka, then foreign currency bonds LATER for poom. frankly, i don't know if i can pull off the timing."

Sounds like a reasonable approach. But the problem this time around is not only the timing of the end of Ka and the start of Poom but guessing at the range of steps central banks may be willing to take to address the problems. How about, "Thanks for buying those two year t-bonds. Presto! They're 10 year bonds now!" It's been done before. Also, one has to ask how much coordination there will be among central banks. If things get bad enough ecnomically they'll get bad politically. I can imagine global central banks taking a less international and more nationalist approach. That's always been the USA's game. You think Volcker's rate hikes were tough on the US economy? Mexico's was still recovering over a decade later.

[EJ]

Re: Eric, are Gold and Silver still in your good books?

What do you make of Prechter's contention that in the great depression the only reason Gold and Silver held their price levels was because of government intervention?

Initially both Gold and Silver prices fell, until the US Federal Government put price floors on them.

Gold bugs hate it when I say this, but gold was only ever "money" because central banks said it was. Cigarettes are "money" if you're in prison, candy bars if you're in a war zone. Money is anything which in its time and place is agreed upon by those who exchange goods and services with each other as 1) a means of exchange and 2) a store of value.

Gold is still "money" in the monetary sense, by proxy, because central banks aren't confident enough in their global fiat money sytem to sell off their gold reserves. If it has no monetary value, why not just sell it? They've had 30 years to do so. What is each central bank worried about? An event that causes them to need to act unilaterally and nationalistically, just as the US always has in the past. Except the world is not as US centric as it used to be.

I believe that Ben's the wrong guy for the job because he's too right about the limitations in the global monetary system in the 1930s. He really believes that if the Fed were not shackled by the gold standard, the Great Depression could have been avoided, never mind the extent of the abuses of the banking and credit system that preceeded it during the bubble period. All the Fed and other central banks would have needed to do is what they did in 2000 - 2004, print their way back to inflation.

Ben will apply his money cure once again, but he may get a lot more than he bargained for, because if the pain is born disproportionately by non US central banks that have other options, they will take them. Then confidence in the dollar as both 1) a means of exchange and 2) a store of value may quite suddenly decline, as the pound sterling did in the 1930s.

To hedge this risk, for insurance (not to get rich), I do the same thing the central banks do: own some gold, and also silver and platinum for diversification.

[jk]

Re: Negative "Positive Feedback Loop" of Employment and Housing

Great points.

"He (big Al) later said that anyone who was still exposed to higher rates was clearly intent on losing money."

At the time, Big Al was talking about short rates and to the boys in the yen carry trade.

the arms adjust to short rates [not the shortest, but short]. so the boys in the yen trade get warnings and joe sixpack is told to finance with an arm?

But the problem this time around is not only the timing of the end of Ka and the start of Poom but guessing at the range of steps central banks may be willing to take to address the problems. How about, "Thanks for buying those two year t-bonds. Presto! They're 10 year bonds now!" It's been done before. Also, one has to ask how much coordination there will be among central banks. If things get bad enough ecnomically they'll get bad politically. I can imagine global central banks taking a less international and more nationalist approach. That's always been the USA's game. You think Volcker's rate hikes were tough on the US economy? Mexico's was still recovering over a decade later.

i have heard of forced conversions of short bonds into longer ones. but i wonder if that could happen today without making things even worse. we have huge edifices of hedges built on the price of the tbond - i don't see how they pull that kind of move in bonds without nationalizing fannie, freddie and just about every big investment and commercial bank. otherwise all those institutions go broke when the bond price discontinuously and drastically resets. doesn't seem likely.

[jk]

Re: Eric, are Gold and Silver still in your good books?

What is each central bank worried about? An event that causes them to need to act unilaterally and nationalistically, just as the US always has in the past. Except the world is not as US centric as it used to be....

Then confidence in the dollar as both 1) a means of exchange and 2) a store of value may quite suddenly decline, as the pound sterling did in the 1930s.

To hedge this risk, for insurance (not to get rich), I do the same thing the central banks do: own some gold, and also silver and platinum for diversification.

i can see foreign cb's "diversifying" away from the dollar over time. it's hard for me to imagine them engaging in some more precipitate action. yes, the world is not as u.s. centric as it used to be, but the dollar is embedded in transactions and asset values and savings around the world. i think the consequences of rapid action might be worse than the cure. what do you picture the foreign cb's doing? none of them want a strong currency. isn't it going to turn into a race for the bottom, at least until foreign [especially chinese] domestic markets grow and mature?

[EJ]

Re: Negative "Positive Feedback Loop" of Employment and Housing

the arms adjust to short rates [not the shortest, but short]. so the boys in the yen trade get warnings and joe sixpack is told to finance with an arm?

yep

i have heard of forced conversions of short bonds into longer ones. but i wonder if that could happen today without making things even worse. we have huge edifices of hedges built on the price of the tbond - i don't see how they pull that kind of move in bonds without nationalizing fannie, freddie and just about every big investment and commercial bank. otherwise all those institutions go broke when the bond price discontinuously and drastically resets. doesn't seem likely.

Takes a certain amount of imagination to guess at what they're likely to do, but not too much imagination.

I honestly don't know, and neither does anyone else. All we can do is list possibilties, assign probabilities, place our bets and pray. As usual, proper diversification and a willingness to move quickly out of one position and into another when a trend change is in the offing are key. As long as we keep the quality of dialogue we have going on here at iTulip through this period, I don't see why we have much to worry about. We'll know.

[jk]

Re: Negative "Positive Feedback Loop" of Employment and Housing

i have to agree and congratulate you, eric, on the quality of the dialogue here. i've been impressed again and again, with the new and knowledgable people contributing.

[Charles Mackay]

Re: Eric, are Gold and Silver still in your good books?

What do you make of Prechter's contention that in the great depression the only reason Gold and Silver held their price levels was because of government intervention?

Initially both Gold and Silver prices fell, until the US Federal Government put price floors on them.

Prechter also said that after the initial deflation (NOW) that gold will be the ONLY asset to own. I'm not a Prechter fan but I've looked around and don't see anything else. Remember that a great percentage of stocks will go to zero, many if not most bonds, munis, mortgage backed securites, money market funds, etc. go to zero, banks fail and your checking account goes to zero. Who ya gonna call? Gold. It's hard to transport a million dollars in corn or soybeans when you're flleeing to Canada or Australia.

[Charles Mackay]

Re: Negative "Positive Feedback Loop" of Employment and Housing

Quote:

Originally Posted by Spartacus What do you make of Prechter's contention that in the great depression the only reason Gold and Silver held their price levels was because of government intervention? Initially both Gold and Silver prices fell, until the US Federal Government put price floors on them.

Prechter also said that after the initial deflation (NOW) that gold will be the ONLY asset to own. I'm not a Prechter fan but I've looked around and don't see anything else. Remember that a great percentage of stocks will go to zero, many if not most bonds, munis, mortgage backed securites, money market funds, etc. go to zero, banks fail and your checking account goes to zero. Who ya gonna call? Gold. It's hard to transport a million dollars in corn or soybeans when you're flleeing to Canada or Australia.

[jk]

Re: Negative "Positive Feedback Loop" of Employment and Housing

Prechter also said that after the initial deflation (NOW)

ka

that gold will be the ONLY asset to own.

poom

[hayfield]

Re: Negative "Positive Feedback Loop" of Employment and Housing

ka

Does that make PM a buy now, because they do the least worst in a deflationary environment?

poom

Or after the ka, because deflated dollars buy more at the turning point? And in the mean time load up on T-Notes while interest rates plummet?

Seems an impossible feat to get the timing right.

[jk]

Re: Negative "Positive Feedback Loop" of Employment and Housing

i think there are too many variable to be able to choose a "best" investment, and that the best we can do is to choose investments compatible with what we think are the several most likely scenarios. in a truly deflationary environment your best investment is long-dated zero coupon tbonds. but as ej has pointed out, the government could in theory play with maturities of already issued securities and thus severely impact that investment. maybe gold holds its value even in the face of deflation because so many of us expect the reflex reaction to produce inflation. maybe gold and bonds both tank and we want to hold cash. does the dollar rise in a flight to traditional safety, so we hold our cash in dollars? or does the dollar tank in anticipation of the inflation to come, and our cash should be in other currencies? in long bonds in other currencies?

so, for myself anyway, i have a variety of investments that will perform well in a variety of environments, and i have my fingers crossed that i've structured them in a way that my gains will outweigh my losses, come what may. we'll see.