Just recently, the Institutional Investor website published a brilliant piece entitled “Asset Manager B.S. Decoded.”

“The investment chief for one institution-sized single-family fortune decided to put pen to paper, translating these overused phrases, sales jargon, and excuses into plain — and satirical — English.”

A Translation Guide to Asset Manager-Speak

• Now is a good entry point = Sorry, we are in a drawdown
• We have a high Sharpe ratio = We don’t make much money
• We have never lost money = We have never made money
• We have a great backtest = We are going to lose money after we take your money
• We have a proprietary sourcing approach = We invest in whatever our hedge fund friends do
• We are not in crowded positions = We missed all the best-performing stocks
• We are not correlated = We are underperforming while the market keeps going up
• We invest in unique uncorrelated assets = We have an illiquid portfolio which can’t be valued and will suspend soon
• We are soft-closing the fund = We want to raise as much money as we can right now
• We are hard-closing the fund = We are definitely open for you
• We are not responsible for the bad track record at our prior firm = We lost money but are blaming all our ex-colleagues
• We have a bottom-up approach = We have no idea what markets are going to do
• We have a top-down process = We think we know what markets will do but really who does?
• The markets had a temporary mark-to-market loss = Our fundamental analysis was wrong and we don’t know why we lost money
• We don’t believe in stop-loss limits = We have no risk management

Wall Street is a business.

The “business” of any business is to make a profit. Wall Street makes profits by building products to sell you, whether it is the latest “fad investment,” an ETF, or bringing a company public. While Wall Street tells you they are “here to help you grow your money,” three decades of Wall Street shenanigans should tell you differently.

I know you probably don’t believe that, but here is a survey that was done of Wall Street analysts. It is worth noting where “you” rank in terms of their concern, and compensation.

Not surprisingly, you are at the bottom of the list.

While the translation is satirical, it is also more than truthful. Investors are often told what they “want” to hear, but actual actions are always quite different, along with the eventual outcomes.

So, what can you do about it?

You can take actions to curb those emotional biases which lead to eventual impairments of capital. The following actions are the most common mistakes investors repeatedly make, mostly by watching the financial media, and what you can do instead.

1) Refusing To Take A Loss – Until The Loss Takes You.

When you buy a stock it should be with the expectation that it will go up – otherwise, why would you buy it?. If it goes down instead, you’ve made a mistake in your analysis. Either you’re early, or just plain wrong. It amounts to the same thing.

There is no shame in being wrong, only in STAYING wrong.

This goes to the heart of the familiar adage: “let winners run, cut losers short.”

Nothing will eat into your performance more than carrying a bunch of dogs and their attendant fleas, both in terms of actual losses and in dead, or underperforming, money.

2) The Unrealized Loss

From whence came the idiotic notion that a loss “on paper” isn’t a “real” loss until you actually sell the stock? Or that a profit isn’t a profit until the stock is sold and the money is in the bank? Nonsense!

Your portfolio is worth whatever you can sell it for, at the market, right at this moment. No more. No less.

People are reluctant to sell a loser for a variety of reasons. For some, it’s an ego/pride thing, an inability to admit they’ve made a mistake. That is false pride, and it’s faulty thinking. Your refusal to acknowledge a loss doesn’t make it any less real. Hoping and waiting for a loser to come back and save your fragile pride is just plain stupid.

Realize that your loser may NOT come back. And even if it does, a stock that is down 50% has to put up a 100% gain just to get back to even. Losses are a cost of doing business, a part of the game. If you never have losses, then you are not trading properly.

Take your losses ruthlessly, put them out of mind and don’t look back, and turn your attention to your next trade.

3) More Risk

It is often touted the more risk you take, the more money you will make. While that is true, it also means the losses are more severe when the tide turns against you.

In portfolio management, the preservation of capital is paramount to long-term success. If you run out of chips the game is over. Most professionals will allocate no more than 2-5% of their total investment capital to any one position. Money management also pertains to your total investment posture. Even when your analysis is overwhelmingly bullish, it never hurts to have at least some cash on hand, even if it earns nothing in a “ZIRP” world.

This gives you liquid cash to buy opportunities and keeps you from having to liquidate a position at an inopportune time to raise cash for the “Murphy Emergency:”

This is the emergency that always occurs when you have the least amount of cash available – (Murphy’s Law #73)

4) Bottom Feeding Knife Catchers

Unless you are really adept at technical analysis, and understand market cycles, it’s almost always better to let the stock find its bottom on its own, and then start to nibble. Just because a stock is down a lot doesn’t mean it can’t go down further. In fact, a major multi-point drop is often just the beginning of a larger decline. It’s always satisfying to catch an exact low tick, but when it happens, it’s usually by accident. Let stocks and markets bottom and top on their own and limit your efforts to recognizing the fact “soon enough.”

Nobody, and I mean nobody, can consistently nail the bottom or top ticks. 

5) Averaging Down

Don’t do it. For one thing, you shouldn’t even have the opportunity, as a failing investment should have already been sold long ago.

The only time you should average into any investment is when it is working. If you enter a position on a fundamental or technical thesis, and it begins to work as expected, thereby confirming your thesis to be correct, it is generally safe to increase your stake in that position, on the way up.

6) Don’t Fight The Trend

Yes, there are stocks that will go up in bear markets and stocks that will go down in bull markets, but it’s usually not worth the effort to hunt for them. The vast majority of stocks, some 80+%, will go with the market flow. And so should you.

It doesn’t make sense to counter trade the prevailing market trend. Don’t try and short stocks in a strong uptrend and don’t own stocks that are in a strong downtrend. Remember, investors don’t speculate – “The Trend Is Your Friend”

7) A Good Company Is Not Necessarily A Good Stock

There are some great companies that are mediocre stocks, and some mediocre companies that have been great stocks over a short time frame. Try not to confuse the two.

While fundamental analysis will identify great companies, it doesn’t take into account market and investor sentiment. Analyzing price trends, a view of the “herd mentality,” can help in the determination of the “when” to buy a great company that is also a great stock.

8) Technically Trapped

Amateur technicians regularly fall into periods where they tend to favor one or two indicators over all others. No harm in that, so long as the favored indicators are working, and keep on working.

But always be aware of the fact that as market conditions change, so will the efficacy of indicators. Indicators that work well in one type of market may lead you badly astray in another. You have to be aware of what’s working now and what’s not, and be ready to shift when conditions change.

There is no “Holy Grail” indicator that works all the time and in all markets. If you think you’ve found it, get ready to lose money. Instead, take your trading signals from the “accumulation of evidence” among ALL of your indicators, not just one.

9) The Tale Of The Tape

I get a kick out of people who insist that they’re long-term investors, buy a stock, then anxiously ask whether they should bail the first time the stocks drops a point or two. More likely than not, the panic was induced by listening to financial television.

Watching “the tape” can be dangerous. It leads to emotionalism and hasty decisions. Try not to make trading decisions when the market is in session. Do your analysis and make your plan when the market is closed. Turn off the television, get to a quiet place, and then calmly and logically execute your plan.

10) Worried About Taxes

Don’t let tax considerations dictate your decision on whether to sell a stock.  Pay capital gains tax willingly, even joyfully. The only way to avoid paying taxes on a stock trade is to not make any money on the trade.

“If you are paying taxes – you are making money…it’s better than the alternative”

Conclusion

Don’t confuse genius with a bull market. It’s not hard to make money in a roaring bull market. Keeping your gains when the bear comes prowling is the hard part. The market whips all our butts now and then, and that whipping usually comes just when we think we’ve got it all figured out.

Managing risk is the key to survival in the market and ultimately in making money. Focus on managing risk, market cycles and exposure.

The law of change states: Change will occur, and the elements in the environment will adapt or become extinct, and that extinction in and of itself is a consequence of change. 

Therefore, even if you are a long-term investor, you have to modify and adapt to an ever-changing environment otherwise, you will become extinct.

To navigate through this complex world, we suggest investors need to be open-minded, avoid concentrated risks, be sensitive to early warning signs, constantly adapt and always prepare for the worst.” – Tim Hodgson, Thinking Ahead Institute

Investing is not a competition.

It is a game of long-term survival.

Start by turning off the mainstream financial media. You will be a better investor for it.

I hope you found this helpful.

Zillow recently published its 2018 housing market report that showed that America’s $33.3 trillion housing market is up by 49% since 2012:

The value of the U.S. housing market continues to climb, gaining 6.2 percent in 2018 to reach a total value of $33.3 trillion. That’s up $10.9 billion from the bottom of the market in 2012 – and a third of the gain has come in California. The Golden State’s value has climbed $3.7 trillion since February 2012, the nation’s housing-crash low. No other state has gained more than $1 trillion in that same span.

The total value of all homes in the New York metro is the highest among metros analyzed, at $3 trillion – on its own accounting for 9.1 percent of the country’s total housing value. Four of the country’s 10 most valuable markets are in California: Los Angeles, which rose 5.2 percent to $2.9 trillion; San Francisco, up 9.3 percent to $1.6 trillion; San Jose, which gained 10.4 percent to $799.6 billion and San Diego, up 3.4 percent to $673.5 billion.

The housing stock in some pricey metro areas is so valuable, in fact, that the total value in one market often eclipses that of all housing in an entire state. For example, all homes in the Washington, D.C. metro are worth a combined $892 billion – which is more than the values of all homes in 40 individual states, including Colorado ($833.8 billion), Arizona ($708.1 billion), Ohio ($695 billion) and Oregon ($451.8 billion).

As I discussed a few months ago in Forbes, I believe that the post-Great Recession housing recovery is actually an unsustainable boom that was fueled by the Fed. This boom is one of the contributors to the U.S. household wealth bubble –

Since the dark days of the Great Recession in 2009, America has experienced one of the most powerful household wealth booms in its history. Household wealth has ballooned by approximately $46 trillion or 83% to an all-time high of $100.8 trillion. While most people welcome and applaud a wealth boom like this, my research shows that it is actually another dangerous bubble that is similar to the U.S. housing bubble of the mid-2000s. In this piece, I will explain why America’s wealth boom is artificial and heading for a devastating bust.

The chart below compares U.S. household wealth (blue line) to the underlying economy or GDP (orange line). In sustainable, organic wealth booms, household wealth tracks GDP very closely. Starting in the late-1990s, however, household wealth decoupled from the GDP as the tech stock bubble helped to inflate American portfolios until it came crashing down in the early-2000s. In the mid-2000s, the U.S. housing bubble boosted household wealth until the 2008 housing crash. Now, here we are in 2018, and the gap between household wealth and the underlying economy has never been larger. This unprecedented gap means that the coming reversion or bust is going to be even worse than the last two, unfortunately.

Plotting U.S. household wealth as a percentage of GDP is another way of visualizing the household wealth bubble. Since 1951, household wealth has averaged 379% of the GDP, while the Dot-com bubble peaked at 429%, the housing bubble topped out at 473%, and the current bubble has inflated household wealth to a record 505% of GDP. Interestingly, the 379% average since 1951 is skewed to the upside by the unusually high household wealth since the late-1990s rolling “Bubble Era.” When the current bubble inevitably pops, household wealth may even fall below its historic average in reaction to how stretched household wealth became to the upside.

Unfortunately, I believe that mean reversion is inevitable as U.S. stock and housing prices (and overall wealth) fall back in line with the GDP. This process will be quite painful for the economy because of the reverse wealth effect that it will create (when consumers feel less wealthy, they spend less). Booms created through monetary stimulus always end in a hangover.

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This past weekend in the NYTimes, Nobel-laureate economist Robert Shiller sounded the alarm on housing again. For those who don’t know, Shiller called the stock market bubble of the late 1990s and the housing bubble of the following decade. He is famous for his house price index and for his method of stock market appraisal called the “Shiller PE,” which judges price relative to past 10-year average real earnings, even if this latter metric comes from the great market analyst Benjamin Graham.

Shiller doesn’t use the word “bubble” in his article, but he argues that since around 2012 we have been experiencing one of the great housing booms in history. And this one is on the heels of the previous great boom and bust. (The third and more benign boom coincided with the great post-war Baby Boom).House prices are now 53% higher than they were in early 2012, meaning they have appreciated at least 7% annualized. Inflation, measured by CPI, since 2012? Less than 2%. That’s a big gain on CPI-adjusted grounds. The excellent graphic below from my colleague, Jesse Colombo, in a Forbes article, tells the price-CPI discrepancy story.

How is it that house prices can surge higher than inflation when median household income is mostly stagnant? Shiller places great importance on the psychological aspects of large price movements. He doesn’t think single economic factors typically tell the story — or the whole story. Therefore, he is skeptical that low interest rates are the primary cause of home price increases. There is some merit to blaming low rates, according to Shiller, and they have been present at the last two bubbles, but rates have actually been going up since 2012, while prices have continued to surge. As Shiller puts it, “The housing market does not react as directly as you might expect to interest rate movements. Over the nearly seven years of the current boom, from February 2012 to the present, all major domestic interest rates have increased, not decreased. So, while interest rates have been low, they have moved the wrong way, yet the boom has continued.”

Another possible explanation is economic growth. But house prices didn’t surge from 1950 through 2000 despite GDP roaring ahead sixfold during that time. And it’s not quite correct either to say prices are normalizing, because they are higher now than at the bubble peak.

Perhaps the home price increases are now a self-fulfilling prophesy, says Shiller. In other words, prices have been going up so people expect them to keep going up. Shiller quotes Keyenes saying, “people seem to have a “simple faith in the conventional basis of valuation.” If the conventional basis is now that home prices are going up 5 percent a year, then sellers, who would otherwise have no idea what to ask for their houses, will just put a price based on this convention. And likewise buyers will not feel they are paying too much if they accept the convention. In the United States, we may believe that the process is all part of the “American dream.”

The price surge can’t go on forever, but Shiller explains that nobody knows when it will stop. All we know now is that prices have surged  as they have only two other times in recorded history. Let buyers and sellers beware. And if you have questions on our views of stock and bond markets, please contact us here.

Earlier this year, I penned an article entitled “The Coming Collision Of Debt & Rates” which discussed the 10-areas that rising interest rates would impact most directly. Number two on that list was housing:

“Rising interest rates slow the housing market as people buy payments, not houses, and rising rates mean higher payments.”

The housing recovery is ultimately a story of the “real” employment situation. With roughly a quarter of the home buying cohort unemployed and living at home with their parents, the option to buy simply is not available.  Another large chunk of that group are employed but at the lower end of the pay scale which pushes them to rent due to budgetary considerations and an inability to qualify for a mortgage.

Even after a “decade of recovery,” the full-time employment-to-population ratios remain well below levels normally associated with a strong economy, and wage growth remains stagnant. Both of which makes home affordability an issue.

Despite much of the media rhetoric to the contrary, I have warned repeatedly that rising rates would negatively impact the housing market which was still being supported by low interest rates.

The mistake that mainstream analysts made was in the assumption that the recent increases in real estate prices were largely driven by first time home buyers creating an organic market. The reality, however, has been that market increases were being driven by speculators in the “buy to rent” game. As I noted previously:

“As the “Buy-to-Rent” game drives prices of homes higher, it reduces inventory and increases rental rates. This in turn prices out “first-time home buyers” who would become longer-term homeowners, hence the low rates of homeownership rates noted above. The chart below shows the number of homes that are renter-occupied versus the seasonally adjusted homeownership rate.”

“Speculators have flooded the market with a majority of the properties being paid for in cash and then turned into rentals. This activity drives the prices of homes higher, reduces inventory and increases rental rates which prices ‘first-time homebuyers’ out of the market.

The recent rise in the home-ownership rate, and subsequent decline in renter-occupied housing, may an early sign of rental investors, aka hedge funds, beginning to exit the market. If rates rise further, raising borrowing costs, there could be a ‘rush for the exits’ as the herd of speculative buyers turn into mass sellers. If there isn’t a large enough pool of qualified buyers to absorb the inventory, there will be a sharp reversion in prices.”

You can see that a bulk of the real estate activity has occurred at the price levels of homes that make the best rental properties – between $200,000 and $400,000.

Importantly, you can see activity has dropped sharply over the course of the last couple of months. This is particularly the case at the very high-end and very low-end of the spectrum.

The latest data on existing and new home sales, permits, and completions show that we have likely seen the peak from the bounce in housing activity that started in 2010. It is important to remember, as we have discussed previously, that there are only a certain number of individuals that, at any given time, are actively seeking to ‘buy’ or ‘sell’ a home in the market. Furthermore, individuals buy “payments,” not “houses,” so artificially suppressed interest rates are only half of the payment equation. When home prices increase to levels that begin to price buyers out of the market – activity will slow.

The chart below is our Total Housing Activity Index which simply combines the 4-primary components of the housing market cycle – permits, completions, and sales of new and existing homes.

You will notice the last time the activity index broke is rising trend, the subsequent decline was not healthy. More importantly, both the current, and previous, “housing bubble” preceded the peak in household net worth.

In both cases, the “pin that pricked the bubble” was interest rates. As shown below, when mortgage rates rise housing activity slows as “people buy payments” rather than houses. This is because higher rates have two immediate impacts on the housing market:

1. The monthly payment rises to a level that buyers can’t afford, or;
2. Buyers stop their activity to “wait and see” if rates come back down again. 

The monthly mortgage payment required for a loan has risen about 12% over the last three years as mortgage rates rose approximately 1%. The simply put houses out of reach for a vast majority of Americans already living from one paycheck to the next.

As a result, and shown below, the annual growth rate of housing activity is back into negative territory.

However, it is really how many of those “permits” turn into “completions” that matter. Currently, that ratio is sending an important warning which is suggesting more troubles ahead for the housing market as “permits” are being pulled due to lack of demand.

At The Margin

Another “Damocles Sword” hanging over the mortgage industry is that rising interest rates will continue to kill the “refinance market.” Banks and mortgage-related companies have made huge profits over the last couple of decades as homeowners serially refinanced their homes to take out cash and refinance at a lower mortgage rate. That activity has largely ceased as a result of higher rates. We are now seeing default risk rise as adjustable rate credit lines on home equity loans begin to exceed homeowners ability to service the debt.

Furthermore, individuals were previously able to sell their existing home and “upgrade” to a newer or larger home. That upgrade was afforded by extremely low interest rates. Now, as rates rise, the “trade up” activity will greatly diminish as individuals become locked into their existing homes.

Housing is always a function of what happens at the “margins” with the activity contained to those actively searching to buy a house versus those willing, or able, to sell. But in order for MOST individuals to engage in the housing market, they need a mortgage to do so. As rates rise, that activity slows.

There is no argument that housing has indeed improved from the depths of the housing crash in 2010. However, that recovery still remains at very weak historical levels and the majority of drivers used to get it this point have begun to fade. Furthermore, and most importantly, much of the recent analysis assumes this has been a natural, and organic, recovery.

Nothing could be further from the truth as analysts have somehow forgotten the trillions of dollars, and regulatory support, infused to generate that recovery. We must also remember that record low mortgage rates driven by Fed purchases of Mortgages Backed Securities (MBS) played a large role in the recovery.

Homebuilder sentiment has gone well beyond the actual level of activity. The recent turn lower is bringing that over-confidence back to reality and with that expect to see a decline in new permits and likely rise in the unemployment rate of those involved in the housing sector.

For the housing market, the recent rise in interest rates is extremely important.  There are many hopes pinned on housing activity continuing to foster the domestic economic recovery. If rates do indeed pop the current housing “bubble,” the entire economic recovery thesis will be called into question.

While the Fed has repeatedly noted the strength of the economy as a central underpinning for continuing to hike rates and tighten monetary policy, it is quite likely the damage from rising rates has already been done. Such was noted yesterday when Fed Chair Jerome Powell reversed his position on hiking rates and changed the language to suggest they were close to finished.

But the Fed’s change of tone may just be “too little, too late” as the negative impacts of increased borrowing costs with respect to both auto loans and housing have already become evident. It is only a function of time until the broader economic indicators feel the pinch.

Throughout modern financial history, the ability to borrow at a 5% rate on a 30-year mortgage was considered a great deal. Over the past ten years, mortgage rates falling to between 3% and 4% have warped perceptions. Evidence of this fact can be found by the sticker shock and home buyer consternation that the currently available 5% mortgage rate is causing. The rate shock is not limited to home buyers; the home building sector has fallen over 30% since it recorded a record high in January 2018. Notably, a month before hitting that record, the popular SPDR S&P Homebuilders ETF (XHB) surpassed the previous record high established at the peak of the housing bubble in 2006.

Mortgage rates play a large role in housing affordability, which greatly affects housing sales and prices, economic growth and the profits or losses for those involved in the housing sector. We discussed and quantified housing affordability dynamics in our article, The Headwind Facing Housing. In this article, we consider whether the housing sector has fallen far enough to warrant investment consideration.

Headwinds Redux

In The Headwind Facing Housing, we produced two graphs that quantify the effect varying mortgage rates have on housing affordability. We modified those graphs, as shown below, to highlight how recent changes in 30-year mortgage rates have affected mortgage payments and housing affordability.

In the first graph, the monthly mortgage payment (excluding taxes, insurance, and other fees) for a buyer purchasing a $500,000 house has risen 12% since 2016. The second graph illustrates the purchase price a buyer can afford for a fixed $2,500 mortgage payment. Since 2016, the purchase price has dropped from $530,000 to almost $470,000. The data in both graphs are based on 30-year mortgage rates rising from 3.87% in January 2016 to 4.83% as of the most recent data from the Federal Reserve. Effectively, as the graphs show, a 1% rise in mortgage rates reduced affordability and increased monthly mortgage payments by about 10-12% in the current environment.

Higher mortgage rates dictate that buyers either take on larger mortgage payments or buy cheaper houses. The burden of higher rates does not solely fall on buyers; it also hurts sellers and those in the housing construction business.

Home Builders

Equity investors appear to be keenly aware of the toxic relationship between mortgage rates and homebuilder profits. The graph below compares the year to date price return for the S&P Homebuilders ETF (XHB) and the S&P 500.

Data Courtesy Bloomberg

Note that while XHB and the S&P 500 both fell in the first quarter, the S&P regained its footing and went on to new record highs before its recent stumble. Conversely, XHB drifted slightly lower following the first quarter decline. More recently, as interest rates rose, XHB fell precipitously. As shown, XHB is underperforming the S&P 500 by almost 25% year to date.

Looking back further, we find that since the recovery from the financial crisis beginning in March of 2009, XHB greatly outperformed the S&P 500. As shown below, in January of 2018, XHB had outperformed the S&P 500 by about 200% since March of 2009. That differential has collapsed over the last few months.

Data Courtesy Bloomberg

Statistically, XHB and the S&P have had a strong long-term correlation (2006-present) of +.71, meaning that 71% of XHB’s price can be explained by changes in the price of the S&P 500.

Interestingly, XHB has a +.21 correlation with ten-year U.S. Treasury yields over the same period. The positive relationship is not what one should expect as it implies that yields and XHB have risen and fallen together. Keep in mind, the relationship is not strong but the positive relationship is notable.

Recently, however, as bond yields broke out of ten-year ranges, reached five-year highs and brushed up against key long-term technical levels, XHB investors became concerned. Since September 2018, the correlation between XHB and ten-year Treasury yields has been -.58 and greatly reflects the lagged effects of rising interest rates on housing activity. We suspect this statistically relevant negative correlation will persist and perhaps strengthen as long as rates keep rising.

Investment Implications

The rest of this article, including our investment conclusions, is only available for subscribers of RIA Pro. To try out this new service with a 14 day free trial period visit us at RIA Pro.

Please note this article will be distributed on our free site tomorrow but the Investment Implications section is only available for RIA Pro subscribers.

Throughout modern financial history, the ability to borrow at a 5% rate on a 30-year mortgage was considered a great deal. Over the past ten years, mortgage rates falling to between 3% and 4% have warped perceptions. Evidence of this fact can be found by the sticker shock and home buyer consternation that the currently available 5% mortgage rate is causing. The rate shock is not limited to home buyers; the home building sector has fallen over 30% since it recorded a record high in January 2018. Notably, a month before hitting that record, the popular SPDR S&P Homebuilders ETF (XHB) surpassed the previous record high established at the peak of the housing bubble in 2006.

Mortgage rates play a large role in housing affordability, which greatly affects housing sales and prices, economic growth and the profits or losses for those involved in the housing sector. We discussed and quantified housing affordability dynamics in our article, The Headwind Facing Housing. In this article, we consider whether the housing sector has fallen far enough to warrant investment consideration.

Headwinds Redux

In The Headwind Facing Housing, we produced two graphs that quantify the effect varying mortgage rates have on housing affordability. We modified those graphs, as shown below, to highlight how recent changes in 30-year mortgage rates have affected mortgage payments and housing affordability.

In the first graph, the monthly mortgage payment (excluding taxes, insurance, and other fees) for a buyer purchasing a $500,000 house has risen 12% since 2016. The second graph illustrates the purchase price a buyer can afford for a fixed $2,500 mortgage payment. Since 2016, the purchase price has dropped from $530,000 to almost $470,000. The data in both graphs are based on 30-year mortgage rates rising from 3.87% in January 2016 to 4.83% as of the most recent data from the Federal Reserve. Effectively, as the graphs show, a 1% rise in mortgage rates reduced affordability and increased monthly mortgage payments by about 10-12% in the current environment.

Higher mortgage rates dictate that buyers either take on larger mortgage payments or buy cheaper houses. The burden of higher rates does not solely fall on buyers; it also hurts sellers and those in the housing construction business.

Home Builders

Equity investors appear to be keenly aware of the toxic relationship between mortgage rates and homebuilder profits. The graph below compares the year to date price return for the S&P Homebuilders ETF (XHB) and the S&P 500.

Data Courtesy Bloomberg

Note that while XHB and the S&P 500 both fell in the first quarter, the S&P regained its footing and went on to new record highs before its recent stumble. Conversely, XHB drifted slightly lower following the first quarter decline. More recently, as interest rates rose, XHB fell precipitously. As shown, XHB is underperforming the S&P 500 by almost 25% year to date.

Looking back further, we find that since the recovery from the financial crisis beginning in March of 2009, XHB greatly outperformed the S&P 500. As shown below, in January of 2018, XHB had outperformed the S&P 500 by about 200% since March of 2009. That differential has collapsed over the last few months.

Data Courtesy Bloomberg

Statistically, XHB and the S&P have had a strong long-term correlation (2006-present) of +.71, meaning that 71% of XHB’s price can be explained by changes in the price of the S&P 500.

Interestingly, XHB has a +.21 correlation with ten-year U.S. Treasury yields over the same period. The positive relationship is not what one should expect as it implies that yields and XHB have risen and fallen together. Keep in mind, the relationship is not strong but the positive relationship is notable.

Recently, however, as bond yields broke out of ten-year ranges, reached five-year highs and brushed up against key long-term technical levels, XHB investors became concerned. Since September 2018, the correlation between XHB and ten-year Treasury yields has been -.58 and greatly reflects the lagged effects of rising interest rates on housing activity. We suspect this statistically relevant negative correlation will persist and perhaps strengthen as long as rates keep rising.

Investment Implications

Despite its label of “Homebuilder ETF,” XHB holds many companies that are not homebuilders. For instance, Whirlpool, Williams Sonoma and the Home Depot represent three of the ETF’s top six holdings. These non-home builders, many of which are categorized as cyclicals, have helped buffet the recent decline. On average, the top five homebuilders in the ETF are down 34% year to date or about 7% more than the ETF.

While it is tempting to buy XHB given its sharp decline, the risks are onerous. The biggest risk is that yields keep rising. This will continue to be a headwind for home builders as housing affordability declines and mortgage payments rise. It will also further pressure the stock market and the economy in general which bodes poorly for the cyclical stocks in the ETF.

Higher mortgage rates will also make it less tempting for consumers to perform cash-out mortgage refinancings or take out home equity loans. Both have translated into a sizable source of revenue for Home Depot, Lowes and other companies in the ETF that profit from home remodeling and furnishing. Those sources of funding for consumer purchases is quickly drying up. Per the Mortgage Bankers Association (MBA): “MBA’s Weekly Applications Survey refinance index averaged 1,013 in June, the lowest monthly average since December 2000. The weekly index value dropped below 1,000 in three of the past six weeks, a level that it has not gone below since December 2000 as well.”

Even if yields peak at current levels and begin to trend lower, we are concerned that the reason for such a reversal in yields would be economic weakness. Heavy stimulus in the form of tax cuts and fiscal spending have boosted GDP by 0.8% so far this year. As the benefits of the stimulus fade, as is widely expected, economic growth should slow and have adverse effects on consumers. The recent takeover of the House of Representatives by the Democrats make new stimulus much less likely to counteract economic weakness.

Despite being in the midst of the second longest economic expansion in modern U.S. economic history, the Congressional Budget Office (CBO) is not currently forecasting a recession for the next ten years as shown above. We, on the other hand, realize that such a forecast is idiotic and, even more concerning, believe the probability of a recession within the next year is significant. A recession would likely result in lower mortgage rates, but the benefits to homebuilders and buyers will likely be offset by job losses, weaker consumer activity and declining consumer sentiment(home buyers).

Despite the recent decline versus the S&P 500 and other sectors, we currently recommend selling or reducing exposure to the homebuilders and the XHB ETF. We believe it is best to wait until the interest rate and economic environment becomes more clear. In our opinion, it’s too early to catch the proverbial falling knife.

To stay abreast of the situation, we recommend following the weekly MBA purchase and refinance surveys as well as 30-year mortgage rates furnished by the St. Louis Federal Reserve (LINK). Other housing data, such as housing starts and new homes sales are helpful, but the data lags significantly, so caution is advised when using that data to infer something about the demand for housing.

This article is Part I of a series that explains why U.S. household wealth is experiencing a dangerous bubble, why this bubble is heading for a powerful bust, and how to preserve and grow your wealth when this bubble inevitably bursts.

This series of articles will cover the following key points:

• How inflated household wealth currently is compared to historic levels
• What forces are driving household wealth to such extreme levels
• A look at the underlying components of household wealth and why they are inflated
• A look at the growing bubbles in equities, housing, and bonds
• How the household wealth bubble is driving consumer spending 
• How the wealth bubble contributes to our artificial economic recovery
• How the wealth bubble is creating a temporary surge of inequality 
• How the wealth bubble will burst
• How to preserve your wealth when the wealth bubble bursts

Part I: U.S. Household Wealth Is In A Bubble

In most people’s minds, any increase in wealth is a good thing. Surely, only a misanthrope would argue otherwise, right? Well, in this article series, I’m going to make the unpopular argument that America’s post-Great Recession household wealth boom is actually a very dangerous phenomenon.

Since the financial crisis in early-2009, household wealth has surged by nearly $46 trillion or 83 percent to a record $100.8 trillion. As the chart below shows, the powerful increase in household wealth (blue line) has far exceeded the growth of the underlying economy, as measured by the GDP (orange line). Household wealth should closely track the economy, as it did during the 20th century until the extreme boom-bust era that started in the mid-to-late 1990s.

When household wealth tracks the growth of the economy, it’s a sign that the wealth increase is likely organic, healthy, and sustainable. When household wealth far outpaces the growth of the underlying economy, however, that is a tell-tale sign that the boom is artificial and unsustainable. The last two times household wealth growth exceeded GDP growth by a large degree was during the late-1990s dot-com bubble and the mid-2000s housing bubble, both of which ended in tears. The gap between household wealth and the economy is far larger today than it was in the last two bubbles, which means that the coming reversion or crash is going to be even more painful, unfortunately.

Another way of visualizing the household wealth bubble is to plot it as a percent of GDP, which paints the same picture as the chart above. U.S. household wealth is currently 505 percent of the GDP, which is even more extreme than the housing bubble’s peak at 473 percent, and the dot-com bubble’s peak at 429 percent. Household wealth has averaged 379 percent of the GDP since 1951, so the current 505 percent figure is completely out of line, which means that a violent reversion to the mean (aka, another crash) is inevitable. To make matters even worse, the 379 percent average figure is skewed upward by the anomalous boom-bust period that began in the mid-to-late 1990s. When U.S. household wealth comes crashing down again, there is a very good chance that it will overshoot below its historic average due to how stretched it has become during the current bubble.

What is driving the current U.S. household wealth bubble and why is it happening? The answer lies squarely with the U.S. Federal Reserve and its actions during and after the Global Financial Crisis. During the Crisis, household wealth plunged as stocks, housing prices, and bonds (aside from Treasuries) cratered. These aforementioned assets make up the bulk of household wealth, so bull markets in stocks, housing, and bonds lead to bull markets in household wealth and vice versa. When household wealth plunges as it did in 2008 and 2009, consumers pare back their spending dramatically, which leads to even more economic pain.

In an attempt to pull the economy and financial markets out of their deep-freeze, the Federal Reserve cut interest rates to record low levels and launched emergency monetary stimulus policies known as quantitative easing or QE. QE basically entails creating new money out of thin air (this is done digitally) and using the proceeds to buy mortgage-backed securities and Treasury bonds with the idea that the massive influx of liquidity into the financial system would indirectly find its way into riskier assets such as stocks. Even though the Fed only has two official mandates (maximizing employment and maintaining price stability), boosting asset prices essentially became their unspoken third mandate after the 2008 financial crisis.

As former Fed chairman Ben Bernanke wrote in a 2010 op-ed in which he explained (what he claimed to be) the virtues of the Fed’s new, unconventional monetary policies:

And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

While the idea of having a central bank like the Federal Reserve boost asset prices to create an economic recovery may seem clever and admirable, it is terribly misguided because asset booms driven by central bank intervention are overwhelmingly likely to be unsustainable bubbles rather than genuine booms. Central bank-driven booms are very similar to sugar highs or highs from hard drugs – a crash is inevitable once the substance wears off. When central banks interfere in markets, they create mass distortions and false signals that trick investors into believing that the boom is legitimate, even though it’s not.

The chart below shows the Fed Funds Rate, which is the interest rate that the Fed raises and lowers in order to steer the economy. When the Fed holds rates at very low levels (which keeps borrowing costs in the economy low), dangerous bubbles form in asset prices and the overall economy. When the Fed ultimately raises rates, the bubble pops, which results in stock bear markets and recessions. The dot-com and housing bubbles formed during periods of low interest rates and popped when interest rates were raised.

What is terrifying is the fact that interest rates have remained at record low levels for a record length of time since the financial crisis, which means that the current market distortion and coming crisis will be even more extreme than the last two. Remember how extreme the current household wealth bubble looked in the two charts shown earlier in this piece? Well, that is certainly no coincidence: it is a direct result of the extremely loose monetary conditions over the last decade.

This next chart shows the Federal Reserve’s balance sheet, which shows the assets purchased by the central bank during its QE programs. Each QE program led to an increase in the Fed’s balance sheet and corresponding surge in asset prices. The three QE programs caused the Fed’s balance sheet to expand by over $3.5 trillion to a peak of approximately $4.5 trillion. Since late-2017, the Fed has been attempting to shrink its balance sheet (this is known as quantitative tightening or QT), which has roiled the financial markets.

Summary – Part I

To summarize, we are currently experiencing an explosion of wealth on a scale that has never been seen before. Unfortunately, it’s not the good kind of wealth explosion, but the bad kind – the kind that precedes wealth implosions that lead to deep economic recessions and depressions. While most people are cheering this boom on and are delighted by the return to prosperous times, they have absolutely no clue what is driving it or the fact that it will prove to be fleeting and ephemeral.

Please stay tuned for Part II, where I will discuss the underlying components of U.S. household wealth (stocks, bonds, etc.) and provide even more evidence that they are experiencing speculative bubbles in their own right.

If you are like most investors, the U.S. household wealth bubble means that your own investments, wealth, and retirement fund are extremely inflated and exposed to grave risk of another crash. Most investment firms have absolutely no clue that another storm is coming, let alone how to navigate it. Clarity Financial LLC, my employer, is a registered investment advisor firm that specializes in preserving and growing investor wealth in precarious times like these.

Please click here to contact us so that we can help protect your hard-earned wealth.

It’s official — house prices are now as high as they were at the bubble peak in 2006 according to the S&P/Case-Shiller 20-City Composite Home Price Index. Moreover, Americans believe they will continue to soar, according to an article by Quentin Fottrell at MarketWatch.. That makes sense from the perspective of behavioral finance. People often extrapolate recent price movements into the future, which contributes to plenty of misjudgments and sometimes bubbles and crashes.

Does all this mean prices are now in bubble territory again? It’s not so easy to say because a bubble is hard to define. But it sure looks like prices are expensive on some reasonable metrics.

First, it has taken 12 years to regain the 2006 bubble peak. That’s a reasonably long period of time. Also, if prices are indexed to 100 in January 2000 and the index is a 209 now, that means home prices have appreciated around 4.1% annualized. That doesn’t seem like a crazy rate of appreciation,  but the problem is that inflation, measured by the CPI has increased by 2.1% over that time. And median household income has increased by 2.2% from 2000 through 2016.

One problem with this analysis is that the 20-City Index might be weighted more heavily to areas where people’s wages are increasing at higher rates than the median. The U.S. economy is bifurcated now, so that people living in the 20 cities in the index might be doing better than people in the rest of the country. The 20-City index contains New York and San Francisco, after all. Also, at least some of the cities in the 20-City Index suffer from severe supply constraints due to onerous zoning regulations.

New Approach to Measuring Affordability

Not only is measuring median prices to median income across the country inadequate, but so is measuring those things in a particular area. Median income and prices don’t capture the full distribution of incomes, and they don’t focus on renters specifically – those best positioned to become first-time home buyers — according to a recent study by the Urban Institute. Nor do median numbers capture the full distribution of home prices. In some areas, for example, there is a wide variety of homes available, but in other areas there is only a narrow set of home types available. Additionally, focusing on renters is important because renters typically have lower incomes, making them less able to afford a home than the median family.

The Urban Institute’s study creates two new affordability indexes called HARI or Housing Affordability for Renters Index, one for local renters and another for measuring housing affordability for nationwide renters who may move to a region. A local index number means that percentage of local renters can afford to buy a home in that area. Local indexes range from 5% to 37%, while the index covering all renters in the nation ranges from 3% to 42% depending on the region to which a renter might move.

Using Washington, D.C. as an example, the paper shows the steps in the methodology. First, renters’ incomes are broken down into 22 intervals of $10,000, and the percentage of the renter population is indicated for each interval. In DC, more than 40% of renters have incomes in intervals of 1 through 6 or $1 through $60,000. By comparison, 15% of new borrowers have incomes in that range. In interval 7, (incomes from $61,000 to $70,000), the share of renters versus new homeowners with a mortgage is similar. In intervals 8 and above, the percentage of renters is less than the share of new homeowners.

Next, borrower probability for each interval level is aggregated to get cumulative mortgage borrower probability. At each income level, the aggregated number represents the share of houses affordable to renters with that income. So income level 10 ($91,000-$100,000), represents 5.2% of DC renters, and those renters can afford 45% of DC homes that have recently sold. Finally, an aggregate of the share of renters who can afford a house in each income interval is aggregated to arrive at the affordability index. For Washington, D.C in 2016, it was 29.6%, meaning 29.6% of renters in DC could afford a house in DC in 2016.

Nationwide renters have lower incomes than DC renters (70% of nationwide renters have incomes in intervals 1-6, compared to 40% of DC renters). And because of this income difference only 17.1% of nationwide renters can afford a house in DC.

Using St. Louis, Houston, San Francisco and Washington, D.C. (two cities that are intuitively more affordable and two cities that are intuitively less affordable), the new indices show that new borrowers are likely to have significantly higher incomes in the more expensive cities. St. Louis has peak borrower probability of 12% at income interval 4, while San Francisco has peak borrower probability – a little over 5% — at income interval 14.

But the affordability index isn’t determined only by incomes of local new borrowers. That statistic is combined with the full distribution of local renters’ incomes to see if renters earn comparable incomes to borrowers. In St. Louis and Houston, most renters fall in the first 10 income intervals. But in the more expensive cities, there are more renters at higher income intervals.

An interesting result from the study is that “cross-sectional investigation shows that the MSA-level indexes vary less than many might expect.” In other words, the difference between the most unaffordable city – Los Angeles, where 18% of renters can afford to buy – compared to the most affordable – Phoenix, where 31% of renters can afford to buy – isn’t that great. Another surprising result is that Washington, D.C. is more affordable (29.6% affordability) than Houston (22.4% affordability) when considering local renters only. Does this also indicate income and wealth bifurcation? The authors don’t say, but it is a surprising statistic.

There is more to the paper, including a comparison of current affordability to affordability in 2005. That comparison is mostly flattering to the current market, and it may have been better for the authors to consider another point of comparison given the strange market conditions in 2005. Nevertheless, these new affordability indices convey a much deeper and more complex reality compared to, say, the rosier National Association of Realtors’ Affordability Index, which has current affordability at over 100 (meaning median income can afford the median home assuming a 20% down payment) in every region of the country.

As a long-time anti-economic bubble activist (both in the mid-2000s bubble cycle and the post-2009 cycle), a very common charge that’s leveled against me is “you’ve been warning about bubbles for years, but the market keeps going up, up, and away!”, “you’re a permabear!,” and “you’ve been missing out on tons of profits!”

Because of the large scale that I’ve been warning on in the media, I’ve probably heard this criticism over a thousand times. The tweet below (from today) is a perfect example of this criticism:

I find these criticisms to be extremely frustrating, factually incorrect, and completely ignorant of the message that I’ve been preaching over and over – here are the reasons why:

• I’ve always said that the best bubble warnings are the earliest bubble warnings, because society needs as much lead time as possible to take action to prevent the bubble. Early bubble warnings also give individuals and families time to prepare for a coming bust and deep recession. Just think of how many people lost their homes, businesses, and jobs during the U.S. housing bust 10 years ago: don’t you think they could have benefited from an early warning?! Of course they would have! It’s common sense (which is not so common, unfortunately).
• “You’re a permabear!,”You’ve missed the bull market!”, etc. This is flat-out wrong: I foresaw and warned of the coming debt and bubble-driven bull market in early-2012 in great detail. I said that we were likely headed for a huge bull market, but it wasn’t going to be a sustainable economic boom, but one that leads to a depression when it pops (which is still ahead).
• “You’ve been calling for a bear market all along, but the market keeps going up!” – Yes, there will be a tremendous economic crash when this false economic recovery/bull market ends, but I’ve always said that you need to “trade with the trend, not against it” (if you must invest or trade). I have said this probably hundreds of times throughout the years, yet I keep receiving the same criticisms over and over. People simply do not listen. I’m at a complete loss as to how to communicate my ideas so that everyone clearly understands my positions. I think people just assume – without paying attention to the important nuances and caveats – that I’m a stereotypical “bear,” which means that I’m calling for a crash at all times.

Lately, I’ve been hearing the criticism “you’ve been warning about this bubble for 10 years now! When are you going to admit you were wrong?!” Yes, I know it’s been seven years (I started warning about the current bubble in June 2011), but even warning about a bubble for ten years isn’t crazy at all – for an example of this, we only need to look to the U.S. housing bubble, which inflated from roughly 1997 until 2007. I believe that someone would have been completely justified for warning about this disastrous bubble for a full decade. Just imagine the kind of criticisms that would be leveled in the latter stages of the bubble in 2005, 2006, and 2007 at someone who had been warning about the U.S. housing bubble since 1997! They’d probably want to hide under a rock, yet they would have been completely correct. I believe that the current bubble is no different.

The chart below shows the U.S. housing price bubble from 1997 to 2007. I believe that bubbles are a process rather than a specific point in time right before they burst. The U.S. housing bubble was actually a bubble even as early as 1998 and 1999, just like the current “Everything Bubble” was a bubble even back in 2011, 2012, and 2013. A bubble is differentiated from a sustainable economic boom and bull market because of what drives it: cheap credit (typically due to central banks holding interest rates low), rapid credit growth, asset overvaluation, rampant speculation, “fool’s gold” booms in various sectors and industries, and the “gold rush” mentality. Sustainable economic booms and bull markets, however, are driven by technological and scientific advances, rising productivity, improvements in governance and regulation, society or the world becoming more peaceful, individuals and corporations saving and investing for the long-term, debts being paid down and improving credit ratings, and so on.

Similar to housing prices, the U.S. mortgage bubble inflated from approximately 1997 to 2007. While someone who warned about this credit expansion for ten years would have been written off as a total crackpot in the latter stages of the bubble, there was a method to their madness. If society had actually paid attention to those early bubble warnings, the ultimate crash would have been far less severe or may not have happened at all. Today’s bubble will prove to be no different: if society had listened to people like me back in 2011 and 2012, the coming crash would be far less severe. Instead, people like me are currently being labeled as crackpots, even though everything we’re saying will make complete sense in the next crisis.

Contrary to the two charts above, the two charts below illustrate how the mainstream economics and financial world thinks about bubbles: they think you are only correct if you warn about a bubble immediately before it pops. How does that make any sense? To me, it’s completely counterintuitive, but I’ve learned that the mainstream world really does think this way based on my interactions with them and the criticisms they keep hurling at me. Wouldn’t you want to try to prevent an economic crisis as early as possible? Of course, but they just don’t see it that way. The greed encouraged by the speculative bubble completely blinds them from seeing the truth. They can only think in terms of their Profit & Loss statement and tactical market timing signals – ie., if you warn about a bubble, that means that you’re calling “THE TOP,” right here and right now. Heaven forbid you’re slightly early, your financial career and reputation is basically ruined.

The chart below shows the U.S. mortgage bubble and how the mainstream economics and financial world thinks of it.

While I believe that the best bubble warnings are the earliest bubble warnings as an anti-economic bubble activist, I obviously don’t approach trading this way! As I explained earlier, I believe you need to trade with the trend, not against it (if you must trade). You should not short early on in a bubble, otherwise you will get destroyed. Again, this is common sense and I’ve said this all along, but people automatically assume that skeptics like me are short all the time. Anti-economic bubble activism is a completely different discipline from successful trading, and this is why people are often confused by my message and position.

The chart below shows total U.S. system leverage vs. the S&P 500. Rising leverage or debt is driving stock prices higher and has enabled the so-called “recovery” from the 2008 – 2009 crash. I have been warning about this bubble since 2011 and I am proud of it. If I could go back, I would warn about it even earlier – in 2009 or 2010. Every economist should have been warning about it. Each year that has passed since the 2009 bottom, leverage continues to increase, which means that the next crash is going to be even more extreme than 2008 was.

Thanks to the current phase of the bubble that has inflated since 2009, the U.S. stock market is as overvalued as it was in 1929, which means that a painful mean reversion is inevitable. How did the market get to this point? It did so by inflating in 2010, 2011, 2012, and so on. Had society listened to people like me who warned about this inflating bubble back then, the market would not be this overvalued. Now, a massive bear market and financial crisis is “baked into the cake” or guaranteed.

Right now, with the market as inflated as it is, greed is the dominant emotion by far. Most economists, traders, and the general public only see Dollar signs right now, not the extreme risk that we’re facing as a society. In their minds, the greatest risk or “crisis” is to have missed out on the bull market. Anyone who plays the role of a naysayer and warns about these risks gets shunned. It is really “uncool” to be an economic skeptic right now, but I’m an unusual person – I don’t care about being popular or cool; I care about doing what’s right, which is warning society against dangerous inflating bubbles. I believe vindication is not far away.

Please follow or add me on Twitter, Facebook, and LinkedIn to stay informed about the most important trading and bubble news as well as my related commentary.

The recent stock market correction, and subsequent rally, revealed the many mistakes that investors consistently make when managing their money. Emotionally driven decisions almost always turn out badly and ultimately impair the long-term investment goals individuals are attempting to achieve.

Given that individuals are consistently promised investing in the financial markets is the only way to financial success, it is worthwhile to review the common mistakes most investors make. After all, if investing is “so easy,” why are the majority of American’s so broke?

Let’s dig into the myths, the mistakes and the steps to redemption. 

Financial pundits across the country consistently promote the myth that one simply buys a basket of ETF’s, or individual stocks, and returns will compound at 8, 10 or 12% a year,

Nothing could be further from the truth.

On a nominal basis, it is true that if one bought an index, and held it for 20-years, they would have most likely made money. Unfortunately, making money, and reaching financial goals, are two ENTIRELY different things.

“The chart below shows the difference between two identical accounts. Each started at $100,000, each had $625/month in additions and both were adjusted for inflation and total returns. The purple line shows the amount of money required, inflation-adjusted, to provide a $75,000 per year income to Bob at a 3% yield. The only difference between the two accounts is that one went to “cash” when the S&P 500 broke the 12-month moving average in order to avoid major losses of capital.”

For the majority of Americans, investing has never worked as promised.

The problem, as I have discussed many times previously, is that most individuals cannot manage their own money because of ‘short-termism.’

Despite their inherent belief that they are long-term investors, they are consistently swept up in the short-term movements of the market. Of course, with the media and Wall Street pushing the ‘you are missing it’ mantra as the market rises – who can really blame the average investor ‘panic’ buying market tops and selling out at market bottoms.”

Sy Harding summed this point up in his excellent book “Riding The Bear:”

“No such creature as a buy and hold investor ever emerged from the other side of the subsequent bear market.”

Statistics compiled by Ned Davis Research back up Harding’s assertion. Every time the market declines more than 10% (and “real” bear markets don’t even officially begin until the decline is 20%), mutual funds experienced net outflows of investor money. Fear is a stronger emotion than greed.

The research shows that it doesn’t matter if the bear market lasts less than 3 months (like the 1990 bear) or less than 3 days (like the 1987 bear). People will still sell out, usually at the very bottom, and almost always at a loss.

The only way to avoid the “buy high/sell low” syndrome –  is to avoid owning stocks during bear markets. If you try to ride a bear market out, odds are you’ll fail.

And if you believe that we are in a new era where Central Bankers have eliminated bear market cycles, your next of kin will have my sympathies.

Let’s look at some of the more common trading mistakes to which people are prone. Over the years, I’ve committed every sin on the list at least once and still do on occasion. Why? Because I am human too.

1) Refusing To Take A Loss – Until The Loss Takes You.

When you buy a stock it should be with the expectation that it will go up – otherwise, why would you buy it?. If it goes down instead, you’ve made a mistake in your analysis. Either you’re early, or just plain wrong. It amounts to the same thing.

There is no shame in being wrong, only in STAYING wrong.

This goes to the heart of the familiar adage: “let winners run, cut losers short.”

Nothing will eat into your performance more than carrying a bunch of dogs and their attendant fleas, both in terms of actual losses and in dead, or underperforming, money.

2) The Unrealized Loss

From whence came the idiotic notion that a loss “on paper” isn’t a “real” loss until you actually sell the stock? Or that a profit isn’t a profit until the stock is sold and the money is in the bank? Nonsense!

Your portfolio is worth whatever you can sell it for, at the market, right at this moment. No more. No less.

People are reluctant to sell a loser for a variety of reasons. For some, it’s an ego/pride thing, an inability to admit they’ve made a mistake. That is false pride, and it’s faulty thinking. Your refusal to acknowledge a loss doesn’t make it any less real. Hoping and waiting for a loser to come back and save your fragile pride is just plain stupid.

Realize that your loser may NOT come back. And even if it does, a stock that is down 50% has to put up a 100% gain just to get back to even. Losses are a cost of doing business, a part of the game. If you never have losses, then you are not trading properly.

Take your losses ruthlessly, put them out of mind and don’t look back, and turn your attention to your next trade.

3) More Risk

It is often touted that they more risk you take, the more money you will make. While that is true, it also means the losses are more severe when the tide turns against you.

In portfolio management, the preservation of capital is paramount to long-term success. If you run out of chips the game is over. Most professionals will allocate no more than 2-5% of their total investment capital to any one position. Money management also pertains to your total investment posture. Even when your analysis is overwhelmingly bullish, it never hurts to have at least some cash on hand, even if it earns nothing in a “ZIRP” world.

This gives you liquid cash to buy opportunities and keeps you from having to liquidate a position at an inopportune time to raise cash for the “Murphy Emergency:”

This is the emergency that always occurs when you have the least amount of cash available – (Murphy’s Law #73)

If investors are supposed to “sell high” and “buy low,” such would suggest that as markets become more overbought, overextended, and overvalued, cash levels should rise accordingly. Conversely, as markets decline and become oversold and undervalued, cash levels should decline as equity exposure is increased.

Unfortunately, such has never actually been the case.

4) Bottom Feeding Knife Catchers

Unless you are really adept at technical analysis, and understand market cycles, it’s almost always better to let the stock find its bottom on its own, and then start to nibble. Just because a stock is down a lot doesn’t mean it can’t go down further. In fact, a major multi-point drop is often just the beginning of a larger decline. It’s always satisfying to catch an exact low tick, but when it happens it’s usually by accident. Let stocks and markets bottom and top on their own and limit your efforts to recognizing the fact “soon enough.”

Nobody, and I mean nobody, can consistently nail the bottom tick or top tick. 

5) Averaging Down

Don’t do it. For one thing, you shouldn’t even have the opportunity, as a failing investment should have already been sold long ago.

The only time you should average into any investment is when it is working. If you enter a position on a fundamental or technical thesis, and it begins to work as expected thereby confirming your thesis to be correct, it is generally safe to increase your stake in that position.

6) You Can’t Fight City Hall OR The Trend

Yes, there are stocks that will go up in bear markets and stocks that will go down in bull markets, but it’s usually not worth the effort to hunt for them. The vast majority of stocks, some 80+%, will go with the market flow. And so should you.

It doesn’t make sense to counter trade the prevailing market trend. Don’t try and short stocks in a strong uptrend and don’t own stocks that are in a strong downtrend. Remember, investors don’t speculate – “The Trend Is Your Friend”

7) A Good Company Is Not Necessarily A Good Stock

There are some great companies that are mediocre stocks, and some mediocre companies that have been great stocks over a short time frame. Try not to confuse the two.

While fundamental analysis will identify great companies it doesn’t take into account market, and investor, sentiment. Analyzing price trends, a view of the “herd mentality,” can help in the determination of the “when” to buy a great company which is also a great stock.

8) Technically Trapped

Amateur technicians regularly fall into periods where they tend to favor one or two indicators over all others. No harm in that, so long as the favored indicators are working, and keep on working.

But always be aware of the fact that as market conditions change, so will the efficacy of indicators. Indicators that work well in one type of market may lead you badly astray in another. You have to be aware of what’s working now and what’s not, and be ready to shift when conditions change.

There is no “Holy Grail” indicator that works all the time and in all markets. If you think you’ve found it, get ready to lose money. Instead, take your trading signals from the “accumulation of evidence” among ALL of your indicators, not just one.

9) The Tale Of The Tape

I get a kick out of people who insist that they’re long-term investors, buy a stock, then anxiously ask whether they should bail the first time the stocks drops a point or two. More likely than not, the panic was induced by listening to financial television.

Watching “the tape” can be dangerous. It leads to emotionalism and hasty decisions. Try not to make trading decisions when the market is in session. Do your analysis and make your plan when the market is closed. Turn off the television, get to a quiet place, and then calmly and logically execute your plan.

10) Worried About Taxes

Don’t let tax considerations dictate your decision on whether to sell a stock.  Pay capital gains tax willingly, even joyfully. The only way to avoid paying taxes on a stock trade is to not make any money on the trade.

“If you are paying taxes – you are making money…it’s better than the alternative”

Steps to Redemption

Don’t confuse genius with a bull market. It’s not hard to make money in a roaring bull market. Keeping your gains when the bear comes prowling is the hard part. The market whips all our butts now and then, and that whipping usually comes just when we think we’ve got it all figured out.

Managing risk is the key to survival in the market and ultimately in making money.  Leave the pontificating to the talking heads on television. Focus on managing risk, market cycles and exposure.

STEP 1: Admit there is a problem… The first step in solving any problem is to realize that you have a problem and be willing to take the steps necessary to remedy the situation

STEP 2: You are where you are… It doesn’t matter what your portfolio was in March of 2000, March of 2009 or last Friday.  Your portfolio value is exactly what it is rather it is realized or unrealized.  The loss is already lost and understanding that will help you come to grips with needing to make a change.

STEP 3:  You are not a loser… You made an investment mistake. You lost money. It has happened to every person that has ever invested in the stock market and anyone who says otherwise is a liar!

STEP 4:  Accept responsibility… In order to begin the repair process, you must accept responsibility for your situation. Continue to postpone the inevitable only leads to suffering further consequences of inaction.  

STEP 5:  Understand that markets change… Markets change due to a huge variety of factors from interest rates to currency risks, political events to geo-economic challenges. Does it really make sense to buy and hold a static allocation in a dynamic environment?

The law of change states:  that change will occur and the elements in the environment will adapt or become extinct and that extinction in and of itself is a consequence of change. 

Therefore, even if you are a long-term investor, you have to modify and adapt to an ever-changing environment otherwise, you will become extinct.

STEP 6:  Ask for help… Don’t be afraid to ask or get help – yes, you may pay a little for the service but you will save a lot more in the future from not making costly investment mistakes.

STEP 7:  Make change gradually… Making changes to a portfolio should be done methodically and patiently. Portfolio management is more about “tweaking” performance rather than doing a complete “overhaul.”

STEP 8:  Develop a strategy… A goal-based investment strategy looks at goals like retirement, college funding, new house, etc. and matches investments and investment vehicles in an orderly and designed portfolio to achieve those goals in quantifiable and identifiable destinations. The duration of your portfolio should match the “time” frame to your goals. Building an allocation on 80-year average returns when you have a 15-year retirement goal will likely leave you in a very poor position. 

STEP 9:  Learn it…Live it…Love it… Every move within your investment strategy must have a reason and purpose, otherwise, why do it? Adjustments to the plan, and the investments made, should match performance, time and value horizons. Most importantly, you must be committed to your strategy so that you will not deviate from it in times of emotional duress. 

STEP 10:  Live your life… The whole point of investing in the first place is to ensure a quality of life at some specific point in the future. Therefore, while you work hard to earn your money today, it is important that your portfolio works just as hard to earn your money for tomorrow.

I hope you found this helpful.

Last week, John Coumarianos penned an interesting piece discussing the surge in home prices over the last few months. To wit:

“The psychological factors are harder to assess. People aren’t flipping condos for sport the way they were during the bubble when mortgages were available to anyone regardless of whether they had income or assets. Yet it seems there’s a widespread desire to own assets – stocks, bonds, and real estate – regardless of price. It’s not an obviously happy mania, where people are motivated by promises of great wealth. It’s more like a need to be an asset owner in an economy that continues to hurt workers without college degrees and becomes more automated. Nevertheless, the price insensitivity of many buyers is enough to cause concern.”

He is right.

Low rates, weak economic growth, cheap and available credit, and a need for income has inflated the third bubble of this century.

John makes a very interesting point of the potential for the recent bump in housing numbers to be part of the global asset chase.

While, there has been much hoped placed on the “housing recovery story” over the last few years, the hopes of a stronger housing-driven economic recovery has failed to emerge. But, in just the last few months, there has been, at last, an uptick in some of the data.

Is the improvement the beginning of “the” long-awaited housing recovery? Or, is it just the final inflation of a combined asset bubble driven by excess liquidity, cheap credit and a “yield chase” of epic proportions? 

Let’s look at the data.

At The Margin

The problem with much of the mainstream analysis is that it is based on the transactional side of housing which only represents what is happening at the “margin.”  The economic importance of housing is much more than just the relatively few number of individuals, as compared to the total population, that are actively seeking to buy, rent or sell a home each month.

To understand what is happening in terms of “housing,” we must analyze the “housing market” as a whole rather than what is just happening at the fringes. For this analysis, we can use the data published by the U.S. Census Bureau which can be found here.

Total Housing Units

In an economy that is roughly 70% driven by consumption, it is grossly important that the working age population is, well, working.  More importantly, as discussed in “Yellen, Employment & Policy Errors“

“This also explains why the labor force participation rate, of those that SHOULD be working (16-54 years of age), remains at the lowest levels since the early 1980’s. This chart alone should give Ms. Yellen pause in her estimations on the strength of the underlying economy.”

To present some context for the following analysis, we must first have some basis from which to work from. Our baseline for this analysis will be the number of total housing units which, as of Q4-2017, was 136,912,000 units. The chart below shows the historical progression of the seasonally adjusted number of housing units in the United States.

(Note: Importantly, despite data released by the marketing arms of the real estate which suggests that millions of units are being built each year. The reality is that from Q1 of 2009 until Q4 of 2017, there has been a TOTAL increase of just 5,911,000 units. This equates to an average increase of just 657,000 units per year.)

During that same period, the population of the U.S. grew by over 21,125.000 or an average of 2.35 million people per year. More importantly, since in order to own a home, one must have a job, those counted as having a job grew by almost 17-million during the same period.

Rising employment and population growth are strong drivers for the housing sector. After all, people have to live somewhere, right? But when we take a look at what homes are being sold, we see a deterioration in the percentage of homes being sold to those that comprise 80% of income and wage earners and an increase in those that belong to the top 20%. 

Furthermore, there continues to be far more houses in the “process” stage (permits, starts and completions) than actual homes being sold.

This activity at “the margin” is further obfuscated by the seasonal adjustment, and annualization, of the data in the monthly reports. However, by analyzing the Census Bureau data of how many homes are sitting vacant, owner-occupied or being rented, we can obtain a much clearer picture of the real strength of the housing market and the purported recovery.

Vacancy Rate

Out of the total number of housing units, some are vacant for a variety of reasons. They are second homes for some people that are only used occasionally. They are being held off-market for one reason or another (foreclosure, short sell, etc.), or they are for sale or rent. The chart below shows the total number of homes, as a percentage of the total number of housing units which are currently vacant.

If a real housing recovery were underway, the vacancy rate would be falling sharply rather than hovering only 0.5% below its all-time peak levels.

Owner Occupied Housing

Another sign that a “real” housing recovery was underway would be an increase in actual home-ownership. The chart below shows the number of owner-occupied houses as a percentage of the total number of housing units available. See the problem here?

There are two important points here.

The first is the recent uptick in “occupied” housing doesn’t equate with the reported rise in home sales shown above.

Secondly, while owner-occupied housing as finally ticked up, it coincides with the recent jump in interest rates which is likely forcing buyers into the market temporarily. However, since rates have everything to do with “payments,” the bounce is likely ephemeral if rates do indeed rise further.

Home Ownership

The reality is that there has been little recovery in housing. With nine years of economic recovery now in the rearview mirror, it is clear that the average American is not recovering as evidenced by the lowest level of home ownership since the 1980’s. The recent uptick, as stated above, coincides with a sharp acceleration in debt as interest rates have begun to pressure buyers.

However, the recent reports of sales, starts, permits, and completions have all certainly improved in recent months. Those transactions must be showing up somewhere, right? 

Buy To Rent

As John notes, prices are rapidly rising in the “hotbed” areas. As the “Buy-to-Rent” game drives prices of homes higher, it reduces inventory and increases rental rates. This in turn prices out “first-time home buyers” who would become longer-term homeowners, hence the low rates of homeownership rates noted above. The chart below shows the number of homes that are renter-occupied versus the seasonally adjusted homeownership rate.

Speculators have flooded the market with a majority of the properties being paid for in cash and then turned into rentals. This activity drives the prices of homes higher, reduces inventory and increases rental rates which prices “first-time homebuyers” out of the market.

The recent rise in the home-ownership rate, and subsequent decline in renter-occupied housing, may an early sign of rental investors, aka hedge funds, beginning to exit the market. If rates rise further, raising borrowing costs, there could be a “rush for the exits” as the herd of speculative buyers turn into mass sellers. If there isn’t a large enough pool of qualified buyers to absorb the inventory, there will be a sharp reversion in prices.

There is no argument that housing has indeed improved from the depths of the housing crash in 2010. However, that recovery still remains at very weak historical levels and the majority of drivers used to get it this point have begun to fade. Furthermore, and most importantly, much of the recent analysis assumes this has been a natural, and organic, recovery. Nothing could be further from the truth as analysts have somehow forgotten the trillions of dollars, and regulatory support, infused to generate that recovery. More importantly, homebuilder sentiment has gone well beyond the actual level of activity.

The point here is that while the housing market has recovered – the media should be asking ‘Is that all the recovery there is?’

The housing recovery is ultimately a story of the “real” unemployment situation that still shows that roughly a quarter of the home buying cohort are unemployed and living at home with their parents. The remaining members of the home buying, household formation, contingent are employed but at lower ends of the pay scale and are choosing to rent due to budgetary considerations. This explains why the 12-month moving average of household formation, used to smooth very volatile data, is near its lowest levels going back to 1955.

While the “official” unemployment rate suggests that the U.S. is at full employment, the roughly 94-million individuals sitting outside the labor force would likely disagree. Furthermore, considering that those individuals make up roughly 50% of the 16-54 aged members of the workforce, it is no wonder that they are being pushed to rent due to budgetary considerations and an inability to qualify for a mortgage.

The risk to the housing recovery story remains in the Fed’s ability to continue to keep interest rates suppressed. As stated above, individuals “buy payments” rather than houses, so each tick higher in mortgage rates reduces someone’s ability to meet the monthly mortgage payment. With wages remain suppressed, and a large number of individuals either not working or on Federal subsidies, the pool of potential buyers remains contained.

The real crisis is NOT a lack of homes for people to buy, just the lack wage growth to be able to afford to. Of course, that probably says more about the “real economy” than just about anything else.

House prices continue to rise. Yesterday a Bloomberg article reported that home prices jumped to all-time highs in almost two-thirds of U.S. cities in the fourth quarter in the face of limited new supply and an improving job market. Rising home prices have spurred the question: Are we in another housing bubble?

Our quick answer is probably not, but prices are elevated. We constructed a chart of the relationship between median home prices and median household income going back to 1987. We used national numbers, including the S&P/Case Shiller U.S. National Home Price Index and Median National Income. Since the home price index isn’t adjusted for inflation, we used nominal household income.

We went back as far as we could using data on the St. Louis Fed website – 1987 — and we found that for the period up until 2000 the index stayed around 100. And that’s what  you’d expect because prices shouldn’t get radically divorced from income. But then a sharp rise ensued peaking at a whopping 153 in 2006. That was the bubble. We’re at 120 now, which is where the index was in the 2003-2004 period. The standard deviation of the data set is 16. So, at 120, we are beyond it using the early 1990s flat period average. But we are not at two standard deviations (which some people use as the definition of a bubble) from that early flat period.

Data from St. Louis Fed

Our chart doesn’t capture the differences in regions and cities. Home prices on the coasts, for example, may be extravagant again. Indeed the Bloomberg article reports that the most expensive markets were San Jose, San Francisco, Irvine, Honolulu, and San Diego, with San Jose experiencing a whopping 26% increase in prices. So some cities might be in bubble territory, but the relative simplicity of our approach indicates where the national market stands compared to the bubble, and also gives a somewhat longer term perspective. A crash in San Jose and other California cities probably wouldn’t affect the entire country or banking system the way the previous housing crisis did, though it could lead to a recession.

Anecdotally, mortgages aren’t as easy to get as they were during the run-up to the bubble. We’ve heard stories from well-qualified borrowers whom banks have assessed with considerable rigor. Still, it’s likely that very low interest rates have spurred the new price increases. Mortgages may not as easy to get for most people, but they are still available. And because enough of them are still available and rates are so low, house prices continue to levitate.

It’s important to note, however, that there isn’t always a strictly mechanical relationship between interest rates and asset prices. Economist Robert Shiller, who is a student of asset price bubbles, rarely mentions interest rates as primary causes of bubbles, and he’s quick to point out that there have been periods of low rates and low asset prices such as in the 1940s. There are always psychological factors involved when prices elevate beyond reason. Still, nobody should ignore low rates. It’s likely that low rates have facilitated the new rise in home prices as well as other asset prices.

The psychological factors are harder to assess. People aren’t flipping condos for sport the way they were during the bubble when mortgages were available to anyone regardless of whether they had income or assets. Yet t seems there’s a widespread desire to own assets – stocks, bonds, and real estate – regardless of price. It’s not an obviously happy mania, where people are motivated by promises of great wealth. It’s more like a need to be an asset owner in an economy that continues to hurt workers without college degrees and becomes more automated. Nevertheless, the price insensitivity of many buyers is enough to cause concern.