Aussie House Prices Face “Perfect Storm”

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In the States overnight everyone went gaga over the news that construction of new U.S. houses rose in February by 22% over the January rate. That’s an annual rate. So we’ll see how it goes. It had been down six months in a row.

Who knows why stocks really rally? But it probably wasn’t the housing news. Prices continue to decline in the U.S. market. Inventories are high. And there is still the matter of millions of Option ARM loans that are still nestled deep in the bowels of the global financial system. We’ll get to them in a moment. Oh yes we will precious.

First, a bit of polly bashing. –“Every single job loss in Australia is a human tragedy,” Wayne Swan has said. “It impacts on families and local communities, as well as the economy.”

Has the Treasurer never been fired? Job losses are indeed a cause for personal distress. We’ve been through a few. You have to regroup, gather your wits, tighten your belt, round up other useful cliches, and do what you can to survive?

But a human tragedy? That is utter nonsense. There are plenty of human tragedies that happen every day. Children die of cancer. Orphans are hit by trucks. Supermodels go hungry.

Job losses are a normal part of the economy. Hopefully you have an economy where new jobs replace the ones lost. This happens if you have a tax and regulatory system that rewards initiative, hard-work, and risk taking. The trouble with the emotional response to job losses, as much as it displays your sympathy and compassion, is that it encourages you to try and build a system where no one ever loses their job.

If you do this, you end up with a system that creates fewer jobs and less wealth. We won’t go into it in more depth. But if you’re keen on the subject, we recommend this essay by Charles Murray.

What about the Aussie housing market, you say? Glad you asked…

“The Australian housing market is facing the prospect of a ‘perfect storm’ of financial pressures, including high mortgage debt, overvalued homes and rising unemployment, which could see prices eventually fall by as much as 30 per cent, investors have been warned,” reads a story in today’s Age. Read it and weep.

There is a lively debate in the comments section over at our website about Aussie house prices. We don’t have much to add. It’s true the market has shown surprising resilience. The Canadian research group that the Age report cites says it can’t last.

“The housing market is looking particularly vulnerable, with over-inflated prices, deteriorating affordability and slowing household income growth…There is an increasing possibility of a major housing bust in Australia.”

It does feel a bit like the eye of a hurricane, although we’ve never been in one. The sky is blue. The sun is out. The wind is down. Let’s have a picnic. We’ll bring the cricket bat and stumps, you bring the food and beer.

On a more serious note, as we’ve written in the introductory article to the March Diggers and Drillers (scheduled for release this week), the only good news in all of this is that you have a pretty good idea of where all of this is headed (huge inflation) and one way to prepare for it (metals and energy shares).

If more bank losses are head (see below) then monetary expansion is on the cards to try and counter it. Deleveraging leads to lower asset prices. The Fed wants to fight it. We’re not saying it will be successful. But there’s no doubt Big Ben will try.

“Bernanke May Need `Massive’ Asset Purchases to Counter Deeper Contraction,” reports Bloomberg. “The Federal Open Market Committee, gathering today and tomorrow in Washington, needs to redouble its efforts after the central bank’s balance sheet shrank 17 percent from a $2.3 trillion December peak.”

Here’s a thought though. The Fed may choose to expand its balance sheet by buying Treasuries. But it may not prop up markets at all. As Peter Schiff noted in a pod-cast last week, the Fed may end up being the only large buyer of Treasuries while everyone else sells. U.S. interest rates will rise and the U.S. dollar will…not rise.

Peter’s suggestion a much more rapid dollar crisis than seems possible at the moment, given the casual way through which officials are waltzing through the crisis. But this G20 meeting in London next month should be interesting. We expect there to be social unrest and violence. We also expect that the world’s investors may realise the markets overseers have no freakin’ clue what they’re doing. After that?

Well, your guess is as good as ours. But we’re looking to gold and oil. More on that later this week.

Now about those mortgages…You remember the good old Option ARM don’t you? That’s the loan that allows you to choose the size of the payment you make on your monthly mortgage. Typically the loan begins with a twelve month introductory rate. After that, you can choose the minimum payment option.

If you choose the minimum payment option, you actually pay less each month that the interest on your loan. That interest is deferred, but it’s added to your principal. That means your principal is growing all the time. This is why these loans were also referred to as negative amortisation (or neg am) loans. You weren’t paying it off. You were actually growing it.

We hope you’ll bear with us for a moment as we go through this. The reason? There’s a slight sense of relief in markets right now. Everyone is throwing stones at AIG. And with the market putting a few good up days, people are losing the sense that our financial system faces serious problems. But they are trillions of dollars serious. And no amount of pleading by the U.S. Treasury Secretary for bankers to lend will change that. More losses are head.

But what size will the losses be? Another trillion? Another two trillion? Well let’s exclude commercial property and loans securitised with credit card receivables or auto loans. Let’s just look at Option ARMs.

Remember, an Option ARM loan “recasts” after five years to a new principal. The interest rate might even stay the same. But if the loan has been negatively amortising (growing as deferred interest payment are added to the principal), then the size of the loan is going to be much larger (an average of 30%, by some estimates).

Even if you’re paying the same interest rate, households at the margin are going to have a much harder time making minimum payments on loans that are 30% larger. And we’re not talking a small amount here. The Washington Post reports that between 2004 and 2007, over US$750 billion in Option ARM loans were originated. The scary part is that, as of late December last year, 28% of those loans were either delinquent or already in foreclosure.

And that’s before the “recasts” have even hit the borrowers. Most “recasts” don’t happen until five years down the track. That means mortgage holders wouldn’t confront the prospect of a higher monthly payment until 2011 or 2012. The chart below from Credit Suisse shows the pig in the python problem.

Source: Credit Suisse

Bernanke has solved the interest rate problem for home buyers with adjustable rate mortgages by slashing short-term rates to zero, effectively. What’s more, he’s conducted purchases of mortgage backed securities by Fannie Mae and Freddie Mac in an attempt to bring down mortgage rates directly.

The looming trouble, however, is that negative amortisation ads to principal. It does so at a time when home prices continue to fall and unemployment is rising. Making a much higher payment is pretty shocking to begin with. It’s near impossible when you’re out of a job.

The trouble will hit sooner than the Credit Suisse chart suggests. Option ARMs automatically recast at the higher principal level once a predetermined loan to value ratio (LTV) is reached. For example, say you take out an Option ARM at an 80% (LTV) and immediately begin making the minimum payment. Your loan automatically recasts at an 85% LTV ratio. In other words, your loan recasts sooner than the five years you expected because of negative amortisation.

This is why the Credit Suisse chart shows a swelling amount of recasts beginning in April of 2009 and peaking in December of this year. It turns out many of those who took out Option ARMs chose the minimum payment. This led to much faster growth in the loan principal, thanks to neg am. And now, it’s going to lead to a much sooner recast of the loan.

As you may know, the current mortgage relief plans in the States, as feeble as they are, do not allow you to refinance your home if you already have negative equity. This means that in the coming months-starting next month-you have millions of home owners who will face much higher monthly payments on their mortgage.

Do you think they’ll pay them? Can they afford to? What will happen to house prices as this wave of neg am Option ARMs goes into default and foreclosure? There could be some real bargains in the housing market.

But for the banks, there will be some real pain. The banks, the insurance companies, the usual suspects, these are the institutions that stand the most to lose from losses on that $750 billion wave of Option ARM recasts. We’re not saying all those loans will go into default. But at the very least, the losses are certain to be taken, even though no one knows how big they will be.

Now maybe all this is “priced in” to bank shares and financial stocks. It’s pretty hard to price in what you don’t know, though. What seems certain is that banks would want to hoard capital in the coming months, not lend it. They face hundreds of billions more in losses, and that’s just from residential real estate (not commercial real estate or corporate bonds).

How will credit recover under those conditions? We reckon it won’t. In fact, the second contraction of the credit crisis could be worse than the first. You should consider that as you ponder your decision to get in our out of the stock market. Think of the number of companies that are already locked out of access to capital and credit. Will that improve in the coming months?

There’s a very real chance it could get much worse. Of course we hope that’s not true. But if it is, it means all those clowns holding press conferences about bailouts and recoveries are just whistling past the grave yard.

If they were smart, they’d be storing up cash and keeping their monkey yaps shut, or better yet, setting up a warehouse to settle all the CDS AIG has underwritten so it doesn’t continue to be a giant conduit between the American tax payer and AIGs counterparties (investment banks and commercial banks that bought CDS from AIG).

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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43 Comments on "Aussie House Prices Face “Perfect Storm”"

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beyondtool
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I think a 50% drop in house prices (maybe not in every area) in the next 2 years is becoming a more and more likely scenario in Australia. We are just sitting at the tip of the iceberg at the moment and already listings are rising. When the second credit crunch does eventually come, hitting a market dealing with unemployment and wage cuts there is only way for house prices to go..

My housing deposit is still growing nicely, just waiting for opportunity to knock.

DrewRiskManager
Guest
I really feel sorry for the first home owners that have been encouraged by the FHOG into this market. I also wonder how many investors? will jump into the market as prices fall say by 10% thinking this might be a bottom only to discover their newly purchased property keeps falling in price. Just my opinion but I think we will test median house prices at 4 times average income at some stage in the future, the pre bubble ratio compared to income. As some of you may know I’m a farmer and a residential property investor who sold his… Read more »
christina
Guest

The U.S. tell us that construction of new U.S. houses rose in February by 22% . Has anybody read that book called “How to lie with statistics” ?

Maybe 2 houses got built in Januray, and 10 houses got built in February. Hey, that’s about a rise of 22% :-)

christina
Guest

Ps- if I make $1 income today, and then the next day I make $2 income, hey presto, I can say that my income has risen by 50%

The U.S. can say anything they like with statistics ,but it doesn’t mean it’s true

Pete
Guest
Your stats are a bit off Christina. Your point is valid though. The Real Estate Institute of Australia (REIA) has been unashamedly and continually releasing stats like this for years now. Do not believe a single statistic they release unless you can verify it yourself. Also ensure that you look at the entire range of statistics, not just the one they choose to report on. Too many times I see them report on growth, when their lone positive statistic is all they could pick out from their entire range of negative ones. It doesn’t take much effort to write a… Read more »
thingy
Guest
beyondtool – can you explain why you suspect a 50% drop? You’d need to have an extreme volume of forced sales for that kind of drop to happen. It’s not impossible but so far the market is defying D&G predictions. I’d agree a correction is to come but 50% – that’s a bit of extreme D&G. Why shouldn’t Oz values be some of the leat affordable in the world? It is one of the nicest coutries to live in. Employment is going to be the key but even if we hit 10%, it still means 9 out of every 10… Read more »
Greg Atkinson
Guest

Pete, I have posted Part 1 of my look at the house prices debate. I have picked up a few of your ideas and worked them into the blog. So far I would say the case for prices falling is really based on a significant and long term recession in Australia, but I am yet to finish looking at the other side of the debate so I will hold fire for a while.

beyondtool
Guest
I think there are a range of factors coming into play. In the future banks are likely to shrink credit, wages will stall while inflation takes over, unemployment may rise marketing in Australia as we are so dependant on imports and exports which are falling. We have no manufacturing sector in Australia to get things rolling again. Interest rates cannot remain this low for much longer, I think they will be rising by early next year if not before. Overseas investors are drying up, whilst imigration has hits the skids due to government regulation (no influx of new buyers). Then… Read more »
technibyte
Guest

Guys, too much information about the USA.
We have a different situation happening over here.

Give us some useful information about Aus!

I don’t really care about the US story!
It’s all about me!!!! (not them damn yanks….)

Bloggers
Guest

Uh, sorry, Technibyte, we don’t have any really scary Australian data to cite. We have to rely on completely irrelevant US and UK data…. sorry! :)

Gerry
Guest

Yes technibite..Over it a bit too… but when the crisis hit in USA the aussie dollar went south in a big hurry regardless of what was happening here at the time. China’s requirement for our commodites depends significantly on exports to USA etc. The flight to “safety”!! was to the US dollar. The main game is still with the USA and the “gravity waves” reach here and elsewhere big time.We have to interpret those gravity waves and there likely impact on our economy and do so in conjunction with our own homegrown issues.

technibyte
Guest

Yes Gerry, I guess the impacts are felt here. However,I thought the article was about Australian housing, but it didn’t seem to be about that at all (Option ARMS??).

I’m just starting to tune out guys. You’re losing me with all of the US-focussed stuff. Sure we feel gravity waves from the US, but we need some information about our situation over here. Isn’t our situation different to the US experience?

watcher7
Guest
Graham Dyer is an Australian “elliottwave technician. His website is http://www.depression2007.com. While I disagree with his position that a depression started in 2007, he has some interesting observations. I speculate in my article “1930s and 1970s for Today: Contraction – Expansion – Contraction?” that we may have anywhere from two to five years of Expansion, as a result of the stimulus due to the first contraction, before the next Contraction, that will be as severe as, or severer than the Hoover Recession – the first contraction of the 1930s. But back to Dyer and some of his comments in his… Read more »
Pete
Guest

I have to agree technibyte.

I have been enjoying Dan Denning’s posts lately because they have mostly been directly related to Australia. And very good articles too. Looks like he’s taking a break in this one though? (and the last one)

I wouldn’t tune out yet if I was you though… :)

Ross
Guest

Labor will cut the 1st homeowners subsidy when they realise they are on a sure bet to have remade NSW Labor’s Homecorp. Not one of those people will ever vote Labor again and it is a big reason they lost Western Sydney to Howard.

Greg Atkinson
Guest

Not sure I get why “Any Japanese readers should, by this time, be rolling on the floor laughing.”?

Biker Pete
Guest
Japanese laughing? Well, he might mean that rents (income) in Japan continued to rise, while interest (costs) fell to zero… and remained there for many years. Japan’s ‘zero-growth’ is one of those highly useful examples unwittingly trotted out by hopeful doom’n’gloomers. Overseas dramas often serve as performance indicators, but those who are banking on a property crash here haven’t considered that in this market, Aussie investors need no capital gain whatsoever. Only a sustained intervention by government to support home construction (the very thing you _most_ fear) can limit rental increases and capital appreciation. Catch 22, ce n’est pas?! :)
DrewRiskManager
Guest
Dont need capital growth what a classic, think about if no growth you loose the same amount as the inflation rate each year off the top of your purchase price (like Japan ask my wife), buddy even at say a modest 4% of the original purchase price it doesn’t take long to make a good size loss. I’m still laughing, dont take my word for it do the math, it never lies. Ah no capital growth required, do we have the smartest housing speculators in the world or what. Here is another little tip negative gearing doesnt work unless you… Read more »
Pete
Guest
Greg: I was thinking the other night (gasp) about the notion of ‘comparing other countries to Australia is not a good enough reason to expect a housing downturn here’. We discussed this in a previous comment, and I agree that neither can provide a direct correlation due to the difference in circumstances. So that is a good argument ‘against’ a people expecting a real-estate fall here. However…it occurs to me that exactly the opposite notion is being used by Real Estate bulls here. Essentially the argument that ‘because we have not (yet) experienced the falls that other countries have, means… Read more »
Novista
Guest

Yeppers … there’s a parallel in state of denial belief systems.

“This time it’s different” equates to “This country is different.”

However, I’ve read, contrary to above comparisons, that NZ is even worse off than the land of oz in terms of most expensive housing. But rubbery figures abound everywhere.

Btw, people should also be reading Steve Keen’s site.

http://www.debtdeflation.com/blogs/

MzPippa
Guest
Someone please convince me with hard facts that we are heading for a 50% crash. Until then, all I can see is that with the Aussie dollar down, our houses are not that unaffordable for many who are right now thinking about moving to the lucky country with the second best currency (and by that I don’t mean the exchange rate) and one of the strongest economy and banking sector currently in the world. I can also see that rental yields are in harmony with interest rates, making residential property a good investment once again, and that that supply does… Read more »
Greg Atkinson
Guest
Pete you will not get any arguments from me regarding the “it won’t happen here” defence. We have heard this all before when people were saying Australia would ride out the GFC because of China, then because of our banking sector etc. If you look at our stock market it is hard to see how we have done any better than anyone else, apart from Iceland ;) It makes me remember all those experts who were talking about how the global economy was now decoupled from the U.S….bah humbug! But I also do not automatically see any logic in thinking… Read more »
DrewRiskManager
Guest
Yeah yeah I Know its completely different here and could never happen. Australian investors are much smarter, arent they biker. Please read the last paragragh a couple of times, just to make sure you get, the take home message. FOURTEEN years ago, Yoshihisa Nakashima looked at this sleepy suburb 20 minutes from downtown Tokyo and saw all the trappings of middle-class Japanese bliss: cherry-tree-lined roads, a cozy community where neighbors greeted one another in the morning and schools within easy walking distance for his two daughters. So Mr. Nakashima, a Tokyo city government employee who was then 36, took out… Read more »
factual
Guest
Lets talk about this bubble with some facts. Lets leave the high fallootin US/UK central banks and what commodity prices will do to the Australian Dollar discussion for those who obviously ‘know’ about these things. Here are some facts about Sydney and the property price bubble. I purchased a three bed investment unit (one year old) in a middle ring Sydney suburb for long term investment in Oct 2002 for $275K. I would be able to realistically sell this same unit for $295K today including the FHBG. Rental return over the last seven years =$250 starting in 2002 rising (quickly… Read more »
Greg Atkinson
Guest

Pete, when I was looking for an apartment to buy here in Japan I came to the conclusion very quickly that it was pointless to try and compare home prices between two countries. There are too many variables such as interest rates,property laws,government grants and local taxes etc. It was hard to even compare prices in the same city! It gets more complicated when you factor in exchange rates and my head spins when I see tables comparing property prices across the world…often they simply convert everything to $USD, like that means something..do they think we all earn $USD?

Pete
Guest
Sorry factual, but you do contradict yourself a few times. Eg: “If it does go belly – up and they loose their job, they can just move back home and rent it out. This will happen to a about 80% of the properties when little Sally realises the expense of looking after herself. Rents will flatline. And so they should.” Wouldn’t this indicate that rents would in fact drop? If rents drop, will those rents be able to cover the interest on the loan? What if interest rates rise? In the worst case scenario, where rents drop, house prices drop,… Read more »
Pete
Guest
One very very big thing that barely gets covered on this topic is the RATE at which people expect change in real estate prices and volume. For instance, I argue that real estate in Australia is in a bubble and current major forces in the economy will drag the market downwards. Others disagree and argue that we are doing fine and compare the CURRENT SITUATION with what is expecting in a market fall. Clearly, the market is not falling anywhere near its peak level. So does that make them right? No. The point is that the market will fall. Will… Read more »
Pete
Guest
One other thing to consider in real-estate: If you take out a mortgage, you do not own your house. The bank does. You don’t own it until you have paid it all off. The idea of buying a house in the face of financial armageddon is interesting – because you will still own the debt, while the bank owns the asset. For those that like bankruptcy as a fall-back option – this might be a problem in the future. As banks become more selective to whom they will lend to, bankruptcy will put a big black mark against your name… Read more »
Pete
Guest

Edit: Point 2) should have include “and higher than inflation” (duh ;))

rick e
Guest

Don’t apologise
Post should be long to cover what angle you are coming from
Are you a high income earner
Middle income earner
Lower income earner
Are you a Property investor
Family man
Young gun

RonPaul for next Aussie PM
Guest
RonPaul for next Aussie PM

interesting article in the AFR Market section today about ARMs, I swear I’d read almost the same thing somewhere else a few weeks back…hmmm

David Collyer
Guest
What a fascinating blogroll. I am a bear on real estate prices, and maybe you will too with an objective look at what current prices mean. The most useful measure it to relate purchase prices to income. Historically this has hovered at between 2.5 and 3 times income. It is currently at six. Before you shrug, think on what this means: anyone buying now commits to thirty years of principal repayments of 20 per cent of their gross income. Not interest, principal – interest is, ahem, extra. And that’s pre-tax, pre-super, pre-HECS, pre-eating, pre-clothing, pre-living. Commiting to a large mortgage… Read more »
Ned S
Guest
David Collyer – Yes, I don’t think you’ll find too many residential property owners are making much of a % return on rent. So pull capital gain out of the equation and real estate is not an attractive investment at all. But speaking quite generally, the same goes for stocks I guess. Would anyone really want to own BHP stocks if they didn’t think they’d get some capital gain over time? (Except an active stock trder perhaps.) I did glimpse a big eye catching add in the top right corner on some internet site recently wanting to pay me 7.25%… Read more »
Greg Atkinson
Guest
Landlords in many parts of Sydney have been doing pretty well.. like so many things do with real estate it just depends on the location. (I would say that last year was much tougher because of the high interest rates) One worrying trend in this whole discussion is we all tend to make general sweeping statements about the property market when in fact there is no one central place that homes are bought and sold. The so called property market is actually a collection of thousands of different markets all with their own characteristics. So what I say for example… Read more »
Ned S
Guest
Greg Atkinson – Three of the real basics re housing prices (interest rates, the FHOG and negative gearing/CGT legislation) are pretty much the same for all of us regardless of where we live I think? And those basics are going to be impacted by commonwealth government perceptions of whether the Australian economy as a whole is looking OK to them or not. So even though as you do very correctly point out, the degree of any possible property price rises and/or falls in different locations will certainly reflect specific localised factors, a lot of the big picture stuff is also… Read more »
Greg Atkinson
Guest

Ned S I see your point but actually first home buyers may or may not also get some extra goodies from their state governments. In addition there are state programs such as Buildstart in the NT. Then across the states we have different levels of stamp duty and land taxes, not to mention local council rates. So all these start to bring in differences even before we even consider wages and household incomes. So maybe the only big picture we really have is one we create, and perhaps this does not reflect accurately how things are on the ground?

Ned S
Guest
Greg Atkinson – I agree with all your points. (Except the last one perhaps? – I’ll need to ask you more on it.) I guess to a certain degree at least, I was thinking in terms of the State differences you mention as being “localised” ones? Very poor choice of wording on my part “State/Regional/Local” would have been way better. But re your last point: “So maybe the only big picture we really have is one we create, and perhaps this does not reflect accurately how things are on the ground?” – I didn’t fully understand but it did cause… Read more »
Greg Atkinson
Guest
Ned S, During much of the Vietnam War the “big picture” view held by many in the Pentagon was the the U.S. was winning the war. To support this view they have graphs and statistics that could show for example how much of South Vietnam was under their control and also the number of enemy that had been killed. As more of South Vietnam came under their control it seemed logical to say they were winning. But as we know the Tet offensive highlighted the flaws in this thinking and as they say, the rest is history. So my point… Read more »
Ned S
Guest
Greg Atkinson – The Vietnam analogy is an extremely good one. Because to my way of thinking at least, it illustrates that: 1. The true situation can and does change over time, and 2. Appearances can be genuinely deceptive, and 3. That governments (like individuals – Hey, governments are just made up of individuals anyway) can certainly fall into a trap of choosing to believe what they would like to believe, and 4. Propaganda is an important tool of governments – Sometimes used honestly to beef up support for their efforts in a “war” they genuinely are winning, or sometimes… Read more »
Thrifty
Guest
Re: Viet Nam Statistics and probabilities are only useful when the correct ones are used. I read the book by Robert McNamara written years after the war. The proper statistics to focus on were not bodycount or area controlled, but supplies required by the North Vietnamese to continue prosecuting the war. The supplies needed could be brought in easily irrespective of how much bombing the US did. This is a fundamental constraint of a guerilla war. As an occupier, you have to take into account that if the opponent has the means to continue fighting, if you can’t change this… Read more »
Greg Atkinson
Guest

Thrifty, did you see McNamara in Fog of War? I thought he made a lot of sense in that..he sure is a smart chap.

Do you believe in reversion to the mean in that price movements for stock and property for example follow a long term trend, and will correct up or down to that trend when they move too far away from this trend?

Pete
Guest
To interrupt your question Greg: I believe in reversion to the mean. But that depends on the timeframe the mean has been tested against. If we use a 10 year mean, we can say that house prices have crashed already and are due for another boom. Obviously that is ludicrous, but it’s still a point. So when we talk about a longterm mean, what is longterm? 30 years? 50 years? 100 years? 1000 years? (that gets a bit tricky) And what is that mean measured against? Is it inflation adjusted? Is it adjusted for anything else? I believe in reversion… Read more »
Greg Atkinson
Guest

Pete, deciding what is long term is the trick I reckon. If you start drawing trend lines on graphs they can vary a lot depending on when you start. Sometimes I think to myself maybe we can get ourselves into a tangled mess of data when in reality the market will do as it wants anyway, no matter how good our logic is :)

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