The Rule of 72 vs. Housing

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In today’s Daily Reckoning, we bring you the story of the Zombie war. On one side, a whole army of bankers, politicians, and economists fighting for a system based on debt and counterfeit money. On the other, the un-dead legion of bad loans in investments created by the credit boom. More on the war in a moment. But first, to the markets…

The markets are actually pretty quiet today. After battling for the better part of three months to get back in the black for the year, the Dow Jones Industrials fell 186 points in New York. We’re not saying the Dow can’t hold the ground it’s gained. But consolidating those gains against the onslaught of more asset deflation is going to take a lot of defence.

And there’s a twist today. You may be surprised with this twist, given how we’ve been pounding the table about the risk in U.S. Treasury bonds. We think that risk is very real and not likely to go away anytime soon, given the $3.25 trillion the U.S. will have to borrow this year. But you should pay close attention to this twist because it may explain the action in the markets for the next few months.

The twist is this: you may soon see RISING U.S. bond prices and a stronger U.S. dollar accompanied by FALLING stock and commodity prices. Yes yes, it’s a complete reversal of recent trends. And it doesn’t mean we are reversing ourselves about the long-term trends. But you cannot remain Orthodox if the facts change. So allow us to explain why this might happen.

Russia’s Finance Minister Alexei Kudrin told journalists yesterday that the U.S. dollar is in “good shape.” He added that, “It’s too early to speak of an alternative [to the U.S. dollar].” These remarks came after Chinese and Russian officials have quite publicly suggested that the world’s financial system would benefit from using a currency that wasn’t being run by a bunch of inflationistas in America.

But the dilemma for the large dollar holders of the world-Japan, Russia, and China to name a few-is how frankly they should speak in public what everyone knows in private. By blowing the whistle on the Fed’s inflationary monetary policy, dollar holders penalise themselves. After all, the rise in oil this year and the fall in U.S. bond prices are both directly related to the perceived weakness of the U.S. dollar-a face pointed out quite publicly by officials in Japan, Russia, and China.

The lesson? There’s a price to pay for rightly pointing out that a huge supply of Treasury bonds threatens the credit rating of the U.S. That price is paid by owners of dollar denominated assets. Yesterday’s remarks by Kudrin, then, should be seen for what they are: a hasty retreat by dollar holders to stem the fall in their investments by reassuring other investors that everything is fine.

In the meantime, you can bet that those same dollar holders are working behind the scenes to find alternatives to the greenback and, of course, to diversify their currency reserves into other currencies or tangible assets. It’s just that you don’t want to precipitate a crisis until you’re good and ready to profit from it with a well-planned trade. Goldman Sachs would never make this kind of mistake.

A fall in stocks and commodities and a rise in U.S. bond prices are also consistent with the technical trends on the major indices we highlighted yesterday. The big bullish moves since the March lows have exhausted most of their momentum. You will now see the secondary trend, a counter rally in bonds as stocks consolidate (perhaps to be blindsided by more financial system issues later, but who knows?)

Does this mean Aussie investors ought to rush out of equities and back into property? Well, if you ask BIS Shrapnel, the answer is probably yes! Yesterday, the firm released a study that concluded Australian house prices will go up an average of 20% over the next three years. We’re not making that up.

“We expect rising confidence in the prospects for an economic recovery in 2010, so investors are likely to return in greater numbers, attracted by increased rental returns and low interest rates,” says BIS Shrapnel senior project manager Angie Zigomanis, who was apparently not informed that Australian banks have begun raising home loan rates.

Blah blah blah. Yammer yammer yammer. Lies lies lies.

Well, okay. Maybe not lies. And to be fair, the BIS report actually admitted that the inflation adjusted gains in Aussie house prices, should they actually materialise, would actually be about half the nominal figure. You’d have something more like a 9%-11% gain over three years, or about 3% compounded after inflation-which is about seventeen percent smaller than twenty.

Even three percent a year seems generous to us, given that Aussie unemployment is still rising. More importantly, the low point of the interest rate cycle has been reached. It’s hard to see how that’s bullish for housing-unless BIS is right and investors dump shares and try to lock in new financing before interest rates rise even further (double digits by 2011, we reckon).

And let us not forget that first home buyers accounted for 28% of all new housing finance in April, according to the Australian Bureau of Statistics. That’s the highest percentage since 1991, the ABS added. The first home buyers aren’t just a marginal force in the market any longer. The lure of government grants has sucked them into the residential property market at a peak in prices and a low point in interest rates. They may be propping up the market now. But when their financial strength fails, it could crush them AND the rest of the market too.

This is simply a disaster waiting to happen for the unlucky first homebuyers, as we’ve said before. Nor does it bode well for the rest of the residential property market. Real estate agents always tell you that the sooner you get on the housing ladder the sooner you can move on up. Buy a house, sell it. Buy a bigger house, sell it. Buy an even bigger house, and so on. There are many mansions in Australia’s property market.

What happens, though, if the lowest rung on the ladder is violently ripped off? If you bring forward years of demand by first home buyers and concentrate all that demand into a thirteen-month period (October of 2008 through the end of this year) what will happen? Hmm.

Well, for one, you will have structurally altered demand for housing finance for years to come. Eventually there’s going to be a drought of new buyers who cannot get credit or cannot afford to get on the ladder without a $30k boost from the politicians. But even that is an optimistic view.

The more negative view is that a large percentage of the FHBs who’ve come in on the current grant package are going to get wiped out. They will be renters for a long time to come. This removes them from future demand for housing finance too.

And so who will investors low on the ladder sell to? Who will people on the second rung of the property ladder sell to if there’s no one from the first rung looking to climb up? And if people in the middle of the housing market can’t sell to trade up, where will demand and the top end come from?

Maybe we’re wrong. We often are, and will be again (and again). But we suspect that the government’s policy to bring demand forward at the bottom end of the market will destroy future demand at ALL levels of the market. And one more point about housing. Quit sending in e-mails telling us it doubles every ten years.

Seriously. Stop it. We’re tired of reading them. Housing does not double every ten years. That is simply not true.

To get the doubling time for any investment you divide the interest rate you’re getting by 72. This is known as “The Rule of 72”. For example, an investment earning seven percent per year compounded would double in 10.3 years (72/7=10.28). You can see how absurd it is to suggest that it’s possible for housing (or any investment really) to grow infinitely at a rate of 7%.

By the way, if you want to see more on inherent possibility of exponential growth-and you are not easily bored-give this video a try. And after reading it, tell us if you agree or disagree with the following statement: a fiat money system accelerates the depletion of resources and the misallocation of capital.

Hey did you see the government of New South Wales has come up with a nifty new policy of buy Australian? The Rees government has said that NSW government departments and agencies have to give preference to Australian-made products when buying uniforms, cars and even trains, according to Sydney’s Daily Telegraph.

It’s not exactly a Smoot-Hawley tariff war to kick off the next Great Depression. But in principle, this is an equally stupid policy. It’s again a case of what is seen versus what is unseen. What will be seen? The jobs that go to Australian companies that make these things.

What is unseen? The cost to NSW taxpayers will most certainly be higher to “buy Australian.” The government will pay more for these things, leaving it with less money to pay for other things. Or, it will raise taxes in order to pay for the higher spending, and the higher taxes leave New South Welshmen with that much less to spend on other products.

Either way, someone always pays the price when the government favours one group over the large group. About the only compelling argument for this kind of policy, in our opinion, is that competition for these goods or services from China (and that’s who this targets) is “unfair.”

That is, if the Chinese-or any other labour market for that matter-are using slave labour to produce goods, it’s a sound principle not to buy those goods. But if it’s not a moral issue and is just an issue of economics, the relevant question is whether these goods and services can be produced in Australia at competitive prices.

We suspect that for industries like textiles, the answer is simply no. Australia, like so many other Western countries, can’t compete on labour or raw material costs with lower-cost manufacturers. Where Western post-industrial economies ought to be able to compete is on quality.

Consumers will always pay more for superior quality for certain goods (textiles, electronics, and manufactured goods). In fact, Japanese and Chinese consumers seem to love French luxury goods, as we recall from our time dodging them outside the shops on the Rue de Rivoli in Paris.

The point is that Western firms can carve out a niche in high-margin manufactured goods and even textiles, provided the quality is excellent. But it’s not something you can do simply be changing a government policy. You have to compete. In the meantime, while we’re measuring how many jobs the NSW policy saves, can we also measure what the higher costs mean to everyone else in NSW?

Finally, we were going to tell you about the Zombie war today. But we’ve run on too long already. More on that from our friend Shawn Cownah tomorrow.

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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36 Comments on "The Rule of 72 vs. Housing"

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ram
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The ‘buy Australian’ policy should prove interesting. For most government procurements Australian companies could provide the goods at much lower prices than the present imports, what we can’t provide is the level of backhanders/bribes/kickbacks that the procurement officials almost always demand – only foreign companies (usually supported by foreign governments) have those kind of resources.

I will be really surprised to see NSW start to have open fair transparent tendering and procurements. Likewise at the federal level.

brc
Guest
Your analysis on a shift forwards of first home buyers skips a small detail : for years the first home buyer participation has been running very low. So the increase in FHB finance is not all brought-forward demand, much of it must also be back-filled demand : those who have been wanting to buy their first home for many years but have found market conditions unfavourable to do so. Anecdotally I have seen many recent purchases which have been this case, “Finally bought a house after years of talking about it” rather than brought-forward plans “was going to do it… Read more »
TheGoat
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BRC, that is a good plan but you presume Aussie housing is currently good value and not over priced to start with. Inflation hedging is not just about what keeps pace with inflation but also the current value versus price for that particular asset or commodity you chose to use for the hedge. You seem to think that its a no brainer that house prices would keep pace with inflation regardless of their current cost. Another way to consider this is to think about “what if” a bubbled property market had held up then inflation started to run, would these… Read more »
prozak
Guest
The Goat, and are you absolutely sure that your commodities are not over valued? You hold OIL and agriculture by what you said so perhaps there is less chance of those being over priced just now. For holders of gold though…. are we so sure? Has anyone done the math on the inflation adjusted price of gold since it became freely traded? Or have all the bulls just digested the rubbish spouted by other bulls… I love the one where they use the spike of 850 caused by fear about WW3 when USSR invaded afghanistan as the base price for… Read more »
Tim
Guest

“….double digits by 2011”. How on earth did you come up with that sort of theory on interest rates? Why would they go that high, that quickly? I’m just a hack at this economics stuff….surely our economy would be absolutely screwed if we hit double digit rates that quickly.

The Outback Oracle
Guest
Yep Tim doble digit rates surely will …but….how the hell are all these govts going to raise all this money they need to ove the next 10 years without high interest rates crippling us all? Take the Aus Govy estimate they need to raise $315 Billion. They come up with this figure using Treasury figures of 4.5 and 4% growth 2011 on. Now Treasury has not been able to forecast the economy 1 month in advance for the last 12 months! How is it going to forecast such high rates of growth 3,4,5 years out? They just assume high growth… Read more »
Lachlan
Guest

Gidday Tim
Interest rates under Paul Keating went way into double digits….and people plus economy suffered. It can easily happen again.

Tim
Guest
I agree that double digit rates are a possible as we saw them under Keating. My real concern is how the rates could rise so damn quickly? Going from the banks current variable rate of around 5.8% to 10% is a 4.2% jump. If they go up in increments of 0.25% there will be approx 17 rate increases from now on into 2011, pretty much one a month or 42 moves of 100 basis points!!! So, for this to ring true in 2010 we are going to see regular interest rate rises (as per the CBA last week and the… Read more »
Ross
Guest
Obama’s comments today paraphrased. unemployment in the western world’s most flexible employment market (toughest dole conditions) is to be 10%. If the projected low growth doesn’t cover required tax receipts then taxes must rise. He won’t allow another bubble recovery and recognises these past bubbles as instruments of the street and as sewing the seeds of the US economic decline. He has the rhetoric right, but republicans will rightly fear his defence of the need to raise taxes rather than debt when they can’t grow and the resistance to cost cutting. Health, ag subsidies, defence and law and order all… Read more »
paul
Guest
i wish more people would have read the book “rich dad, poor dad”. if you havent i’d suggest borrowing a copy or even buying one faster than you can say “property is a hole in the land you pour money into”. the lesson i learnt foremost from the book was you have to avoid the finance merry go round like the plague. hey, if you want to “pay off” a home over a number of years go for it but you cant complain if the bank seizes it because you lost your job, or drops in value in a dramatic… Read more »
TheGoat
Guest
MMM was oil overvalued. My average buy price is $44.70 currently trading $70 have PUT options at $64. Always pays to have insurance on the down side of your hedge. If prices continue to rise the current options will expire worthless and plan to option again in the $80s. I’m not a gold bug but I do see the thinking behind those who are. For me as an actual user of oil and a producer of grain, I lock in favourable spreads. As a grain producer I am ALWAYS long USD (my future prices in AUD are made up of… Read more »
brc
Guest
My submission on buying a house was as a place to live in, not to pick up 10 negatively geared investment properties. My point was that you might as well buy a decent place to live in, because it has hedged inflation so well in the past, particularly during the 1970’s, the last time inflation got out of control. You may say housing is currently overpriced : maybe it is, maybe it isn’t. But we aren’t talking 50 or 100% overpriced, maybe 20% at the worst. Doesn’t take too much inflation to take care of that. And you need to… Read more »
Biker Pete
Guest

Love ya stuff, Paul. “… you cant complain if the bank seizes it because you lost your job, or drops in value in a dramatic way, thats your speculative fault you joined the mindless herd.”

While so many tenants believe “…houses will come down…” they’re kindly a.) paying off our properties; and b.) giving us an income. Investors like us would be sunk in deep ship if ‘Sons of Rich Dads’ like you suddenly all bought houses…! :)

Biker Pete
Guest

Right on, brc. And if it’s your OWN home, you can be “…peeing out the window…” ;)

Ross
Guest
Ah BRC and the longing for the 70’s when you could castigate Whitlam for the wage-price spiral breakout led by the public sector and yet at the same time you reaped the rewards of his policies by were paying off that sweet old fixed rate mortagage in 1/3 of the inflation adjusted price and time! There are plenty of Bodega conservatives out there with the chardy socialists. Keating, Howard and Costello are among them. Now though, due to the household savings glut having gone on forever past the 60’s, the banks just credit wrapping short term offshore bond funding. So… Read more »
TheGoat
Guest
To be sure a hard asset will be better than cash. I just find it hard to believe that every other country who has a known house bubble, had big increases in prices which turned out to be based on specualtion and easy credit, that this wasnt the case here in OZ – Hard to say but it is known Australian cities are all in the top 15 of most expensive cities in the world to buy, based on average incomes. On the other hand I see double digit returns on cropping country and grain prices rapidly increasing. I know… Read more »
TheGoat
Guest
BRC you might be right Aussie housing might prove to be a great inflation hedge but I’m not so sure looking back at the 70s you are comparing apples with apples. House prices in the 70s were 3 to 4 times average yearly income (which they had been for the preceeding 40 years) they are now 7 to 8. Actually if you google AMP Dr Shane Oliver, he did an interesting piece re house prices during the last recession, yes house prices didnt fall in price terms but when adjusted for inflation they did. I’m just not so sure a… Read more »
Pete
Guest
Right on Goat! For all the people that think real estate will be a good inflation hedge, consider: 1) you must make gains equal to or higher than the rate of inflation 2) if you borrow money to do it, interest rates will likely equal the rate of inflation, meaning you will need gains roughly double the rate of inflation (crazy huh) 3) if no-one else has any money to splash around, and credit is hard to come by, who could possibly buy your property at these increased prices? Yes, wages will go up, but will they match inflation? Unlikely.… Read more »
Biker Pete
Guest

Just pay the rent on time while you wait, wait, wait for the crash PETEnant… ! :)

Lachlan
Guest

Talking of crashes, a stock market collapse is looking more and more likely. Bar some exceptionally cheap gold stocks I got on Tuesday. Although Im aware of pending investment flows into commodities possibly near term there is still no signs of higher than normal inflation yet. Unless somebody can show me otherwise?

Greg Atkinson
Guest

Lachlan..if you feel money will flow into commodities then this will drive up prices. If commodities prices go up then this tends to give inflation a kick along. Unless of course there are strong deflationary forces at play as is the case where I am in sunny Japan.

And who is talking about a stock market crash? Don’t tell me a routine sell off has woken up the doom crowd again? Why is it that people always get spooked by the end of fiscal year equities sale?

Joe
Guest
Tim, Standard variable rate at the moment is about 5.7 – 5.8%. Under a package I am paying 5.04% with the NAB on a variable rate. I am awaiting to have this fixed for 3 years at 5.54% (paperwork is being prepared and posted). The rate has been confirmed as in play (since the fixed term increases announced this week by the NAB) by their representative. But the point you are making that double digit rates by 2010 cannot happen is all too wrong. There are great inflationary pressures built into the World economy. Inflation in the U.K is still… Read more »
James Nashville
Guest

Biker Pete, you said: Love ya stuff: “While so many tenants believe “…houses will come down…” they’re kindly a.) paying off our properties; and b.) giving us an income.”

And the day that (a) and (b) stop, I will be dancing in the streets. My position (very hard-working, but paradoxically poor tenant) and your position (pompous, turgid landlord) are fundamentally based on aleatory conditions, which can – and will – change. The truth is, your (enviable) financial position is also continent on you (unenviable) age. Enjoy my rent old man.

James Nashville
Guest

Biker Pete, you said: Love ya stuff: “While so many tenants believe “…houses will come down…” they’re kindly a.) paying off our properties; and b.) giving us an income.”

And the day that (a) and (b) stop, I will be dancing in the streets. My position (very hard-working, but paradoxically poor tenant) and your position (pompous, turgid landlord) are fundamentally based on aleatory conditions, which can – and will – change. The truth is, your (enviable) financial position is also contingent on you (unenviable) age. Enjoy my rent (for now) old man.

brc
Guest
Anyone with a variable rate mortgage at the moment needs to seriously look at the yield curve. Fix for as long as you can. You don’t need to outdo inflation with a fixed rate loan : it doesn’t even matter if your property isn’t keeping up 100% in real terms, as long as the mortgage is getting eaten by inflation and the value is going higher than the mortgage. Obviously this depends on not having a fixed income or an income you can negotiate yourself (ie, you’re not on a unionised wage) and that wage keeping up with inflation. All… Read more »
Tim
Guest
Joe, thanks for the reply. I never said that rates couldn’t hit double figures by 2011… I don’t know enough about all this economics and finance stuff to make any sort of hypothesis! I was more interested in the mechanics which could make rates rise so damn quickly; it just seems like an extremely dramatic rise over a relatively short period of time. There always seems to be “events” or “data” in the media engineered by interested parties protecting their billions (or trillions) which manipulate the true mechanics of markets and as such I would have thought that “something” will… Read more »
Biker Pete
Guest

Thanks, James… we do! _Twice_ as much, appaRENTly :)

Lachlan
Guest

Hello in sunny Japan Greg
My letter did not come out the way I thought I wrote it. I did not buy any stocks on Tuesday. I did dispose of some speculative energy stocks though (not oil). Anyhow sorry for ambiguity. Yes I am counting on the inflation thing coming to bear sooner or later whether domestic, US or worldwide (likley)hence my position on gold (and also because Im a gold nut). Figured twas a good time to take the money and buy back in lower….hopefully.
It will be very interesting to see how the inflation/deflation plays out in time.

Greg Atkinson
Guest

Lachlan yes we sort of have to wait and see. There are so many governments getting involved with the markets these days it is hard to know where anything is heading! I just read the RBA was selling $AUD in May so there is another little factor in play. I would reckon a nasty inflation problem will pop up in Oz but when…and more importantly what will the authorities try and do about it?

Ned S
Guest

Lachlan – I know you like gold – That’s great for mine. But just know that when it turns, gold can hurt very badly. I say that because I had a Grandad who bought two(?) ounces in the 1970s. My Mum (his daughter who inherited 1 ounce) commented to me in about 2005 that the old boy would have been been glad he’d finally gotten his money back. (Personally, I think he might have had higher hopes for it than that? Getting his money back after 30 years of inflation??????) But as a sometimes dutiful son, I didn’t argue.

Lachlan
Guest
Good morning all…from sunny Australia actually. What a magnificent day here in Qld. Ned Im counting on far greater depreciation of fiat in the coming years but I will concede there are no certainties in life. However I had to pick a horse so to speak. Concerning inflation in the US. Despite so much money creation I cant see any extra in the hands of consumers yet. Banks are very tight on lending despite their bailouts which are apparently parked back where they came from ie the Fed. If somebody can show me otherwise that would be appreciated. I suppose… Read more »
Pete
Guest
Hi all To all you property bulls out there I would like to say the following 1. for property to double every 7 to 10 years would require a growth of 7 – 10% annually see rule of 72 re doubling. 2. Assuming a generous 3% per annum wage increase, wages will double every 24 years. 3. It does not require a Phd in economics to see that an assumption of house price doubling every 7 years leads to approx 3:1 doubling against wages. 4. Assuming median house price Melb A$ 450K, average wage A$ 56 K, then by the… Read more »
Greg Atkinson
Guest

Pete just a few quick questions. Why do home prices need to be 3-4 times the national average wage…shouldn’t we be looking at disposable income? Also do you apply the same logic to gold?

Ned S
Guest
Pete – One more to consider? I think a lot of Australians just may have (and have had) the thought in the back of their mind that they’ll use their super to pay out their mortgage on retirement. I think I can see the logic: Let the boss pay into super; Don’t worry too much about the mortgage; Live well now; Use a lot of the super on retirement to pay off the house; Cry poor and hold one’s hand out for the pension; Get all the additional benefits/concessions; And sleep well knowing that one’s retirement is not heavily exposed… Read more »
Biker Pete
Guest

Lots of ‘if’ maths, Pete. Hope you’re not counting on these ‘iffy’ maths for shelter… . ;)

rodger
Guest

So house prices will fall..where?.The demand is so great in areas of the coal,iron ore mining i cant see happening north of rockhampton may be in southern states where no one wonts to live..The mines are ramping up again guys…

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