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About this week’s show:

  • Real estate: Buy, sell or hold?
  • Climbing interest rates could kill real estate recovery
  • Loonie, Aussie and Dr. Copper are critical tell-tails

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, I was just looking at the paper this morning, the Durango Herald, our little local paper, and I just commented to my wife how excited I was that good friends of ours, one in particular that I am thinking of, who is a top realtor in our area, actually made a pretty good income last year. Home sales were up, a seven-year high. It’s been a bad seven years, but finally, he’s really come out of what I would consider one of the toughest real estate slumps that we have ever experienced.

David: Certainly in our lifetime have experienced. If you roll the clock back, there are periods of increase and there are periods of decline, and you find that there are two variables that drive the real estate market. Demographics. If you have a demographic boom, then yes, real estate booms, to the degree that you have a demographic bust, you really have a headwind for growth in real estate. The other element, other than demographics, is interest rates. If interest rates are expensive, just imagine a seesaw. The higher the interest rates on one side of the seesaw, guess what’s on the other end? The price of homes. So when you get low rates, then you have the seesaw tilting the other direction, with very high home values. And I think that is why interest rates and interest rate trends factor in so heavily into our views, not only the bond market, because that is the other side of the equation for bonds, but also for real estate. Because again, the cost of financing a purchase, very few people purchase a home with cash, the majority are purchasing with the help of the bank, and so the interest cost is very intriguing, very considerable, We’ll talk about that a little bit later, but just as a punctuation mark here in our conversation, for every 1% increase in interest rates, you are talking about losing almost 11% in terms of affordability for a home.

Kevin: That’s an amazing statistic. Just like in cooking a dish, sometimes you don’t know what the secret ingredients are. Interest rates, a lot of people don’t really realize that the secret ingredient doesn’t lie within our own borders. The secret ingredient, actually, is coming from the emerging markets, it’s coming from Asia, it’s coming from people who are willing to still buy our artificially low interest rate bonds. If those start rising in price, or if we start losing those people as clients, for whatever reason, then we could have a problem with real estate again, couldn’t we?

David: That’s right, so for you and me, when we look at our balance sheet and say, okay, we own this home, and either we own it free of debt or we have debt on it, we are concerned about its direction because we care about whether our balance sheet is growing or not. Did we lose money on the home purchase? Are we making money on that home purchase? And maybe it’s not something you price in real time, but every year or two, 3-4 years, you check in and say, I wonder what home prices are doing in my area. What most people don’t know is that your area is not necessarily determinate of real estate values. Again, work with me here, because I think what is happening in China today is of absolutely critical importance to a U.S. homeowner. This is what is happening right now as we transition toward the Chinese New Year. It is called the Year of the Horse, this next year, and unfortunately, we are moving into a phase where investors could be getting kicked by the horse on the very first day of the year. You have China Credit Trust Company which has warned investors, in Forbes magazine, that they may not be repaid when one of its wealth management products matures on January 31st. That’s the first day of the Year of the Horse. And I think what is important to know is that this is one of thousands, if tens of thousands, of WMPs, what are known as Wealth Management Products, which have been used as vehicles to take investor capital and basically fund a lot of development and infrastructure projects off of the balance sheets.

Kevin: And this is a country that has been growing 7-8% a year, and yet they are still saying, “Wait a second, we’re not going to be able to pay you when it matures.” So could we have a Lehman moment brewing in China right now?

David: And that’s really what we are talking about, something that happened very similar to what was developing in the 2003-2007 time frame here in the United States, what we came to know as the shadow banking system, where you could look at the banks and say, “How much leverage do they have?” But it wouldn’t give you a very, or a completely accurate, picture of how much leverage was in the financial system because those same financial firms had developed financial products through what they would call financial engineering. Structured finance is a subset within a major bank, and they put together products which they can then sell to individuals or to institutions, and it allows for even more borrowing or leverage to be associated with that financial institution. It gears their earnings much higher, and it gives the misperception that they actually have some real balance between equity and debt, when, in fact, they may have far more in terms of liabilities and debt in the equation. And that is, in fact, what those structured products try to obscure or cover over.

Kevin: Well, lest we forget, I remember when Bear-Stearns came out, and they had just 400 million dollars’ worth of what we now call toxic debt to offer to the market. Well, the market didn’t want it. 400 million bucks is nothing compared to the trillions we have now tried to spend to get out of this crisis, but that was sort of the shot heard round the world, really, Dave. When that debt wouldn’t sell, it became apparent, and all the other debt through Lehman Brothers, and AIG. It was a problem at the time that couldn’t be fixed.

David: What we have in Asia, and particularly China, is sort of the yin and the yang. On the one hand, you, just this last year, had emerging market weakness. So you are talking about a lot of your developing countries who did very poorly. If you look at the U.S. stock market versus a lot of the emerging market stock markets, a stark contrast. We did well, they did not. Then you have the emerging market currencies, which, for 2013, they went through a meat grinder last year, as did the emerging market bonds.

Kevin: Interest rates rose.

David: Now, there is an exception here, and if it is difficult to wrap your mind around the world of economics and finance, I appreciate what your frustration may be, because guess what? You’ve got mixed communications and mixed messages coming. We just mentioned the fact that we could have a Lehman moment in China here within the next week or two. On the other hand, we have last year, which is a classic example of what the Chinese are putting in place as a long-term strategic advantage, specifically, the Chinese bond market was very stable this last year. What are known as the dim sum bonds that trade in Hong Kong, and are really the first foray for the Chinese government to issue the equivalent of what we have as treasury bills, bonds, and notes. That’s what they call them, dim sum bonds.

The Chinese currency was very stable last year, so when you compared your emerging market brethren, and clearly, maybe you can make the case that it is no longer an emerging market, they are developed, but they did very well. We did not. Our bond market didn’t, even here in the United States, and the emerging market bonds were terrible, along with their currencies. So they stood out as a beacon of light at a port in the storm in 2013. Again, the mixed message is, the yin and yang in this equation, is China doing well? Are they forging a path toward displacing the U.S. in terms of global economic leadership? Or do they face critical elements which could take them, not back to the stone age, but certainly, put them on their heels, and in a defensive position, focused just on domestic issues, as a result of all of the shenanigans that have been played in their banking system, and frankly, in their shadow banking system, completely unregulated.

Kevin: A country will act a lot like an animal, even George Washington talked about this, a country that is in danger will do whatever it takes to get itself out of danger before it starts looking abroad. What we are talking about is, how does the cost of a bowl of rice in China, or the cost of interest rates in China, how does that affect what we are talking about in the Durango Herald this morning about home sales? Well, it affects it dramatically, because the Chinese are the ones who are allowing us to artificially keep our interest rates low. That, and quantitative easing, these emerging markets are buying a lot of that debt, and if they can’t, if they get defensive, then at that point, who are we going to sell our debt to?

David: Right, and thus, what happens to our interest rates? Mortgage rates last year, at this time, we have just witnessed 50-year lows in mortgage rates. The national average came in at about 3.32% and Robert Campbell of the Campbell Real Estate Timing Letter, and for those of you, particularly in Southern California, but perhaps across the country, a great resource. His focus is mainly on Southern California, but again, the Campbell Real Estate Timing Letter is worth taking a look at if you have interests in Southern California real estate. He was pointing out that for each 1% rise in mortgage rates, it impacts the buyer’s purchasing power, as I mentioned earlier, by 10.75%.

Kevin: It’s like the cost of the house goes up 10.75% as far as affordability.

David: As far as affordability is concerned, because that interest rate variable is so important. And he goes on to say that given last year’s 13 to 13.6 rise in housing, that is just the pricing of a house, coupled with the move higher in rates, again, from 3.32% to about 4.5%, it is no surprise that the National Association of Realtors, their affordability index, drops to a 5-year low.

Kevin: So David, we’re looking at an improvement in prices, but we were looking at improvement in prices before the crash, and it was becoming unaffordable, real estate, at that time. You are saying that this is starting to step up again?

David: Yes. There’s good and bad here. We are 23.7% off of the cycle lows in real estate, so if you pick the lowest point that real estate got, looking at the Case-Shiller Index now, we are 23%, almost 24% off of those lows. We are still, for perspective, about 20% below the 2006 peak valuations for that Case-Shiller 20-city index. So where do we go from here? 2014 is likely, in our opinion, to be a good year for U.S. real estate. You have the Fed, which has reiterated its choice of favorite assets. What is that specifically? Mortgage-backed securities. Real estate is fully supported by the Fed via its purchases of mortgage-backed securities.

Kevin: Isn’t it almost all of them? It’s been over 90% for years now.

David: Right, so they basically are the real estate market, they have played their hand and said, this is important, this is what we consider as the driving force of economic growth, home ownership. And that’s likely to continue, even if the Fed does reduce its treasury purchases, also known as the taper. So the catch 22 is that while the Fed is buying mortgage-backed securities, and that helps in many regards, it certainly helps the flow of capital into the real estate market. It also helps liquefy market operators, financial institutions. It is allowing for financial products related to housing to flow seamlessly through the system. But here is the catch: By not supporting the treasury market as much, again, the taper and reduction of 10, maybe 20 million dollars.

Kevin: Interest rates start to rise.

David: You are ultimately pressuring mortgage rates higher, even if you are buying mortgages. And don’t forget how mortgages are priced. It is relative to the 10-year treasury. As goes the treasury market, so goes the cost to borrow for a home purchase. Do you care about the cost of borrowing as it relates to a home purchase? Absolutely. If you are a first-time home purchaser, or if you are a refinance candidate, yes, this matters to you, very greatly. But what we are saying it that you have to care about more than just U.S. monetary policy, you have to care about what is happening overseas, because guess what? One of our primary purchasers of U.S. treasuries, and one of the means by which we have maintained low interest rates, is this relationship with the Chinese, is this relationship with the Japanese, and their willingness to buy our treasuries. To the degree that they are fixated, focused, distracted by home-grown issues. We certainly hope things don’t escalate in terms of their local or regional tensions between those two countries. That would be a game-changer.

Kevin: Speaking of local and regional, one of the things about talking to clients over the last, almost three decades, about real estate, is that you can rarely generalize, because regions do different things at different times. Some regions are growing. Some people are listening to this right now, saying, you know what? It may be picking up in Durango, Colorado, but it isn’t picking up here. You can listen to people in Phoenix, or Vegas, or wherever, where they had a huge slump. Now they are getting a huge boom. So how is the regional side of things looking? Is everyone growing? Where are we?

David: Broken into four regions, west, midwest, south, northeast. Real estate growth rates began to decelerate, they began to slow in November of this last year. It may be reasonable to assume that you get slower sales in the winter months, but this is not just seasonal month-on-month declines in growth. This is slower growth rates comparing year-on-year numbers, as well. Growth rates are growth rates, I’m not arguing that. This is almost like talking about Chinese growth, right? 7.7% is great. It’s not 10%, it’s not 11%, it’s not what it was, but we’re not complaining about growth. We’re still seeing growth in the real estate market. But I would say this. You have one of the lead guys who runs the Case-Shiller Index, David Blitzer, who has said here recently that the housing market is living on borrowed time. You have to take that into consideration. Things are improving. Things aren’t as good as they were. There is a pickup in sales. There are segments where sales are better than others. Mid-tier housing is moving. It can be financed by Fannie Mae and Freddie Mac, and that’s really what you are talking about. If it is a conventional loan related to the house, guess what? It’s gonna go. Why? Because Fannie Mae and Freddie Mac, via the treasury market, and via the Fed, if you are connecting all of those dots, it’s supported, you’re going to get financing. It’s very easy to get financing. When you move to a jumbo purchase, or a jumbo loan, you’d better be bringing a lot of cash to the table. Otherwise it’s much more difficult to finance.

Kevin: I think what I’m hearing you say is that right now things seems to be okay in real estate. Don’t mistake this for another real estate boom like we saw a decade ago. But if a person is thinking about either buying more real estate, or possibly lightening up and unloading, it seems that you may be saying, don’t load up on real estate right now, and if you want to lighten up, this is a good year to do it.

David: Yes, again, we think that momentum will hold prices together this year, 2014. But anyone wishing to downsize or sell property should prioritize that this year. This is just a market adage. You sell into strength. We’ve had a number of years of weakness. We think that there are structural headwinds which still have to be dealt with before we have real sustainable growth in the real estate sector, so what you have here is a gift via the Fed. Tons of money-printing has gone to subsidize growth over the last couple of years and the recovery that you see is built on the backs of Fed financing. That is not our view of a healthy market. That is not our view of what ultimately would be in the category of organic growth. Here are some interesting points, though. Why should home values hold together this year? You have a reduction in foreclosure filings. You have a reduction in repossessions from banks. You have an increase in building permits. There is a number of things which say, okay, well, listen, we’ve picked up some momentum. The momentum will carry a certain distance, but as you dig into, particularly those building permit numbers. I think this is very interesting. It tells us a number of things which are important to keep in mind. Again, if you own real estate, this is going to be important to you. Single-family home permits have increased 100% from the lows in 2009. We were at about 90,000, now we’re at about 180,000. For perspective, that is still below your 2004-2008 average of over 400,000 building permits, but we’re off the floor, and in fact 100% better. But more interesting is the 225% increase in multi-family dwelling permits. That is up from 400,000 units to 1.3 million and we are nearly back to pre-crisis levels.

Kevin: So David, what you are saying is, on single-family homes, the permits have increased, and it’s substantial. It’s not quite back up to what it was when the boom was hitting, but as far as multi-family dwelling permits, this is more the person who is buying rental properties. We are almost back to pre-crisis levels.

David: Or who is building rental properties with the intention of renting them out. Yes. One of the fallouts of the crisis was the loss of equity and balance sheet catastrophe experienced by many people who bought homes and maybe shouldn’t have, or perhaps they just had unfortunate timing. They are back to being renters and thus you have an increased demand for multi-family dwellings, not individual single homes. You see the difference?

Kevin: Right, the renters are back. Well, you have even pointed out in the last few shows, rent is really getting high. That really seems to be where the speculation is with these large firms that are buying up thousands of rental properties at a time.

David: Yes, the Census Bureau ran their numbers. The Census Bureau says rent has increased by 4.4%. The Fed says, 4.4 is your number, we come up with about 2% and change, and that’s how they factor owner-equivalent rent into our inflation numbers. So, you have the Census Bureau who, according to the Bureau of Labor Statistics, is not adding up their numbers correctly. We would say, actually, it is the Bureau of Labor Statistics that doesn’t know how to add, but I guess that’s another story, and a similar, familiar rant.

So with renters back on the scene, vacancy rates are low, and in fact, they are at about a 12-year low. Renters are back. Housing demand is biased toward multi-family dwellings and that is now squeezing multi-families into one dwelling, that is your duplexes, your four-plexes, your apartment complexes, etc., where you have multi-families, many families, under one large, large roof. That tells us a lot. Two times as many apartments have been built since 2009 compared to single-family homes. If you want to argue for a housing recovery, you should consider that point very carefully. Yes, excess inventory has been removed, and as you mentioned, a lot of that is hedge funds coming in and buying blocks of foreclosed homes, that is helpful. But you also have shadow inventory still held with banks where properties have not been put on the foreclosure market, and that has boosted prices, there is no question. So, not being a naysayer, glad to see home prices recover, bought a house myself in 2009. Glad to see that home prices have recovered since those depressed lows. But the numbers indicate a far greater demand for rentals. Ownership, relative to demographic growth, is not a pretty picture. And so this is really the key issue. Home ownership rates are at the lowest at this last year, going back to 1995. So home ownership is not improving, even though real estate is supposed to be improving. Does that strike you as odd?

Kevin: And something else strikes me as odd. We’re going to go back to those hidden ingredients in the whole mix of real estate still rising. I’m going to go over, actually, Dave, to the excuse that is used by central bankers around the world so that they can continue to keep interest rates low, and print money, and quantitatively ease, and buy up mortgages. I think of Christine Lagarde right now. She is talking about the ogre of deflation. You talked a couple of weeks ago about how in a strong society, where technology is actually increasing our access to things and our transportation of things, we should have deflation. Things should be getting cheaper and cheaper and cheaper, because it is getting more efficient to get it to us. Yet, central bankers continue to make us fear the very thing that we should be experiencing, and that is, deflation, a good form of deflation.

David: But we do have the conflict between the doves, those who would like to see more accommodation by the Fed and the world’s central bankers, including Janet Yellen, and the hawks, those who are concerned about inflation and the unintended consequences of money-printing. So I wonder what will be Yellen’s parting shots. You and I were just talking about this the other day, Ben Bernanke reflecting on quantitative easing. He said, “The problem with quantitative easing is that it works in practice, but it doesn’t work in theory.”

Kevin: Right. He tried to get a laugh out of it, but it’s sort of arrogant that he said that.

David: Right, well, and what else did he say about quantitative easing. Most studies have found that quantitative easing is at least somewhat effective.

Kevin: This is 4 trillion dollars into this thing. It’s somewhat effective?

David: Right. And then he said, “Well, the Fed did the right thing…I hope.” I do wonder what Yellen says at the end of her term. But one of my favorite Fed officials at the Dallas Fed is now saying, “Listen, we’ve got to do something, and do something fast. If we don’t reduce this massive money-printing, we are going to sow foul future growth in America.” And he said, “For those of you unfamiliar with the term, beer goggles, the urban dictionary defines it as ‘the effect that alcohol has in rendering a person who one would ordinarily regard as unattractive, as alluring.’ Things often look better when one is under the influence of free-flowing liquidity. This is one reason why William McChesney Martin, the longest-serving Fed Chairman in our institution’s 100-year history, famously said, ‘The Fed’s job is to take away the punch bowl just as the party gets going.’”

So there is growing contention within the Fed. “Guys, you’re priming the pump for inflation and you have to be careful here. If you haven’t already done it, we’re going to end up with an inflationary problem. On the other side of the equation, as you mentioned, Christine Lagarde says, “No. No, no, no. What we are still facing is the ogre of deflation.”

Again, you look at this in sort of a yin and yang balance. What different currents of information do we have that imply we should be concerned about inflation on the one hand, or deflation on the other? Or maybe stagflation, some combination of the two, with stagnant wage growth and increasing prices, which may be more of the case when all is said and done.

But there are a few indicators that we look at, and we wanted to share with our listeners, the Canadian dollar and the Australian dollar. These, for us, are leading indicators of a re-emergent deflationary trend. Why is that? These are countries that sell lots of stuff. We’re talking about iron ore, we’re talking about lumber, we’re talking about just stuff, and that stuff gets used in building of other stuff. So right now we’ve got a hiccup in China. They’re not importing as much as they were, and lo and behold, we have major layoffs, in fact, one of the worst years for layoffs in Australia, going back to, I think, 1992. And you see it reflected in weakness in the Australian dollar. The Australian dollar has been weak this year. The Canadian dollar has been weak this year, and the final confirmation of a radically slowing global economic picture would be for copper to break below $3 a pound. As you know, many people call copper the commodity with a Ph.D. in economics, and it has yet to confirm these declines in the Canadian dollar and the Australian dollar. But it is something that I think our listeners should definitely pay attention to. The loonie, what they call the Canadian dollar, began to deteriorate in earnest from its trading, actually, above parity to the U.S. dollar. It was in more than a 1-to-1 relationship, it was more expensive, you could say, of greater value, than the U.S. dollar, just a few months ago. It is now trading 10% lower from its 2013 levels.

Kevin: David, you are going to have to explain to me, with the value of the Canadian dollar decreasing, I don’t understand fully how that is actually tying into a deflationary trend. What does that mean?

David: We are really talking about three canaries in a coal mine. Again, there is too much debt in the system. We already know there is too much debt in the system. And we know that the world’s central banks have done one thing to solve the debt problem. They’ve thrown more debt at it. So that ultimately does imply that we are right back where we were in 2007, 2008, at the beginning of the crisis, because nothing structurally has changed. We haven’t solved the problem. All we have tried to do is paper over it. What you should look at, in terms of a leading indicator of getting to the point where you just can’t keep up with the debt anymore, are things that imply what is happening in real economic terms.

Kevin: So David, what you are saying is, the countries that produce stuff are just not selling stuff. Yeah, we’ve created trillions of dollars, and various countries have been trying to paper over this, but the demand for their stuff, and in this particular case, like with the Canadian dollar, the demand even for their currency is declining. We’re not in a recovery. That’s the bottom line.

David: Precisely. And so what we have been witness to, not only in the stock market here in the U.S. this last year, is really, the result of brilliant financial engineering. The problem is, brilliant financial engineering does not substitute for free trade, and transactions occurring between, not only people, but between countries, so all this is to say that when the global economy is growing, demand for raw materials increases. Commodity-producing countries are the beneficiaries of this, both in terms of the volumes of exports, and in terms of currency appreciation. What we are seeing is not an indication of growth, but the opposite. Central bank infusions of capital have boosted demand to a small degree, but they have yet to jump-start organic growth. So what we are watching now is these three canaries in the coal mine. You have your Canadian dollar, which again, they export tons of raw materials, but they are not exporting as much as they were, and it’s having an impact, not only on their economy, but on their currency. The Canadian dollar, the fact that it is slipping now, and is at a technical level of support at 90, this is very important to us. If it breaks these levels of support, we go back to where the Canadian dollar was trading circa 2008 and 2009.

Kevin: Then you brought up the Australian.

David: Yes. And again, they had their worst layoffs this last year since 1992. And its currency is reflecting weakness. You know what is going to happen? They are going to compound the weakness in the currency by the Australian Central Bank saying, “Hey, wait a minute, we can’t afford to have a slowdown in the economy. We don’t care if we are having to see all these major layoffs because trade is diminishing with China and our other trade partners. We are going to have to stimulate the way the U.S. has. We are going to have to stimulate the economy the way the Japanese have, we are going to print more of our currency. And guess that that gets us into, Kevin? It gets us into an inflationary downward spiral. But the problem is, we are, in fact, facing a deflationary cause to what in the end, ends up being an inflationary downward spiral because central bankers only know how to address deflation one way.

Kevin: That’s the only way…look at Germany back in the early 1920s. It’s the same thing. You address a deflationary cause with an inflationary printing, and then it turns into hyperinflation. Gosh, it’s not rocket science.

David: Central bank activism, what we have had here in the United States with the Fed, money-printing, quantitative easing, asset purchases, all of this, and it has been duplicated in other parts of the world, it’s at odds with organic growth, to the degree that it promotes consumption and spending, not on the basis of income growth, not on the basis of job creation, but via additional debt. It’s ultimately as smothering as a wet blanket to fire. The world’s central bankers have papered over the problems of 2005-2008. A debt problem, at its core, was addressed by adding more debt, and it’s no surprise that 2 of the 3 canaries in the coal mine are now singing. The Australian dollar weakness, Canadian dollar weakness.

Kevin: Well, then copper.

David: Yes, that’s the last support. Watch copper. If we are trading at $350, $330, great. We need to be heading toward $4 a pound. And if we’re not heading toward $4 a pound, then what Dr. Copper is telling you is that we are getting ready to go toward another round of deflation. Now, what is the trigger for that? Maybe it is this China Credit Trust Company and the Year of the Horse, getting kicked in the teeth by the horse, and it being, again, not a trigger in the U.S. real estate market, what we had circa 2008, but maybe a trigger in someone else’s market, but with the reverberations coming back and impacting not only U.S. housing, but ultimately our ability to finance our own deficits inexpensively. All of these things are interconnected.

Kevin: It seems like we should continue to encourage maintaining liquidity, and maintaining caution, because if you just look at the news right now, it seems that there is growth. You have to be looking, like you said, at these canaries. Think about the coal mine. You’re down there, you’re doing your work, it’s just one day, let’s say it’s sometime in the middle of the week, everything is just running together, you’ve got thoughts of your family, you look over to the side and you see a dead canary.

David: It tells you something is wrong, you need to get out, there’s more gas in there than will support your life system.

Kevin: David, guess what? But you’re busy. You’ve got other things on your mind. Okay, so it’s a dead canary. There are two other canaries. They’re still chirping.

David: Right.

Kevin: Okay, but what you are saying is, there are three canaries right now that are sort of tipping something off right now and the tipoff is, you need to get out of the mine.

David: An interesting conversation I had this week. A client, quite reasonably asked, “Why not add an exposure to productive commodities?” Specifically, asking about an oil company. As opposed to just defensive commodities like gold and silver. My colleague, David Burgess, pointed out that in the case of the major oil producers, yes, you have had price appreciation, which has been attractive over the last 2-3 years, but the means by which virtually all oil producers have accomplished this has been unnatural and unhealthy. Shell is an example. Look at the last 5-7 years, they have reduced the number of shares outstanding by 10-15%. We’ve talked about this ad nauseam for the last month or two.

Kevin: Sure, boost the earnings per share. Makes things look better than they are.

David: Meanwhile, that company has gone from 37 billion in debt to over 70 billion in debt. You think to yourself, “Well, gracious. Oil is selling at ten times what it was a decade ago. They’ve got to be making money hand-over-fist.” Why are they leveraging up? Why are they, in essence, destroying their balance sheet, making themselves much more cyclically sensitive and vulnerable when it comes to supporting a 70 billion dollar debt load. Why? It doesn’t matter what the price performance has been, you have to look at the income statements, you have to look at the balance sheets, and that is where the real story is told. You want to talk about a canary, there are all kinds of warning signs that we have too much leverage in the financial system, not only amongst the financial institutions, but the general run-of-the-mill Dow 30, the Blue Chips!

Kevin: (laughter) Well, you know, I can’t help but laugh, Dave. This is not a laughing matter, but I’m just thinking about these canaries, and for those Monty Python fans, going back into the late 1960s, 1970s, when they were filmed, it was weekly show in England. There was a skit in one of the Monty Pythons, it is one of my favorites. John Cleese goes in and buys a bird. Well, the bird immediately dies at the pet store, and he says, “This parrot is dead. I need to bring the bird back.” The owner says, “Oh, no, no. No, he’s just merely sleeping.” And the whole skit is someone trying to convince John Cleese that that parrot is not dead, he is actually a live parrot.

But we have signals right now, Dave, that have been consistent throughout the years, that are telling us that we need to not take things at face value right now, but we need to prepare. What you are talking about with real estate. Okay, enjoy the fact that we may have a good real estate year because the Federal Reserve has committed to keeping rates low, but gosh, if you have too much real estate on the books, you’d better lighten the load because this is not something that is going to last.

David: Where is the organic growth coming from? Whether it is a Shell Oil Company, which again, for many of these publicly traded companies, the companies are becoming a “shell” as they are taking out the value and compensating their top employees. Meanwhile, the long-term shareholder value is being destroyed. You look at that kind of activity and realize, “Wait a minute. Price is one thing, value is another.” What you are not getting is real long-term shareholder value, but you are getting a decent price today. I say you take the decent price and run.

And the same with a second home, a third home, a fourth home. If you have an over-exposure to real estate, yes, you should have 25% of your assets in real estate. We’re not saying go to zero, but for someone who has 50, 60, 70, 80, 90% of their assets in real estate, just understand that interest rates and demographics are the drivers, and if you don’t have the equivalent of a baby boom in your neighborhood, in your town, in your state, in your country, guess what you are solely dependent on? You are dependent on financing, and that is interest rates in the variable of value creation. Are you going to see an increase in price on the basis of lower interest rates, or are you going to see a decrease in price on the basis of higher interest rates?

Coming out of 2013, going into 2014, I think the dangerous thing to assume is that we have a good information feed. The market gives us an indication of value and that indication is price, and price discovery, and yet, we have had the Fed, the Bank of Japan, the Bank of England, the European Central Bank, with a larger footprint in the marketplace, than they have ever had before, in terms of influencing prices.

Kevin: It messes up price discovery. How do you really know the real price of anything when they are just printing money.

David: And how can you determine the real risk of any asset when the price is skewed, when it is messed up, when it is disturbed by this massive influx of capital, creation of debt, creation of money, whatever it may be, in these various markets around the world.

Kevin: David, you were talking about messing up the blood of the pricing. You think about people who get blood transfusions, sometimes other organs. The system can either accept or reject the organ. If it accepts it, it still has an impact on the system. I think of blood transfusions. I was reading an article the other night that said, “Red blood cells don’t necessarily carry a nucleus with a new genetic code coming into the acceptor from the donor.” But actually, there are enough white blood cells in there that you can still see traces of the other donor for a year-and-a-half or more. They still haven’t figured out exactly how that affects the genetic code, but you have this same type of thing coming in. You have bad pricing coming into the market right now, and it is affecting everything, the long-term ramification. The Bible talks about unequal weights and measures, and an unequal weight or measure has long-term consequences.

David: And that is just, again, the skewing or price, the mispricing of a particular asset. This is very disturbing to me, thinking about the number of people we encounter who look at the equity markets today and say, “It’s where it should be. It’s actually a fairly reasonable price. I think we should buy it here and now. Why not own real estate? It makes all the sense in the world. Look at price appreciation, it’s doing quite well.”

No argument. No argument, it has done well, it will continue to do well. This should be a great year for real estate. I want to know what is driving the price over the next 3, 4, 5, 7 years, because frankly, you are talking about a totally illiquid asset. You’d better know where your liquidity is coming from. You bought it today. What is tomorrow? Is it tomorrow, as in next Tuesday? Is it tomorrow, as in three years from now? If you are assuming that you’ve got liquidity and you are going to get the price you want, you may be assuming more than you should be about, frankly, all of these markets. The stock market? Yes, we think it is overpriced, as Andrew Smithers said, 50-75% overpriced at this point. The bond market? Even Bill Gross would say, “Gosh, interest rate trends, they’re turning and going the other direction. The cost of capital, interest rates, they’re going higher. Bond prices are going lower. Prepare accordingly.”

Real estate. Real estate behaves the same way as bonds do because they are an interest rate-sensitive asset. And so to assume that we can see growth for the next 3, 5, 7, 10, 15 years, you’re putting together a real estate portfolio, just understand, your income may be secure, but guess what is not secure? The value of the asset, itself. And by the way, how are those assets repriced, in terms of income relative to money market, you are now unattractive. In other words, you may lock in a 5% rate of return on a real estate project today, but what happens when your tax-free bond is paying 6%? Or your treasury bill or bank deposit is paying 7.5%? All of a sudden you look and say, “Why would I buy real estate that is illiquid for 5.5%? Guess what happens to the value of the property? It is discounted accordingly until it reflects the market rate. This is the problem, Kevin, the market rates have been destroyed by central bankers.

Kevin: One of the ways that you can actually recapture the consequence, because the consequence will be things snapping back to their correct levels, that’s what history tells us, and so you step aside, you put it into gold. I’m not saying everything, but you make sure that you have enough gold cash liquidity that you can come back in and buy that repricing.

David: You have to allow markets to do what they always do, which is, snap back to reality, and not be propped up artificially. This is not reality. It’s not that we’re uninterested in real estate. It’s not that we’re not uninterested in equities. It’s not that we’re uninterested in bonds. In fact, I prefer all of those assets.

Kevin: They’re just the wrong price right now.

David: They’re the wrong price. So what do you do in the interim? Leave your money to be managed by Janet Yellen and Ben Bernanke, and 600 Ph.D.s who have accomplished one thing in 100 years? To diminish the purchasing power of your dollar by 96%? How’s that for a pedigree? I don’t care about the pedigree. I don’t care about the Ph.D. Show me results. They’ve failed. That’s where you want to put your money?

We’re left with very few options. And we are in an interim period, a transitional period, where economic realities still have to play out, and as they play out, then you return to what every investor needs to make a wise decision, accurate pricing, true price discovery. When you have accurate pricing, true price discovery, you know what risk is, you know what reward is, and you know how and when to place your assets.

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