Real Estate in 2016 “We are not in Kansas Anymore”

A Note By 
Branson to a Real Estate Investment Team

This was written to and for a real estate investment team.

Warren Buffet credits his great success to being lucky to be born in the USA.  We are in the best economic position in the world right now.  The global economic environment continues to evolve, and because we can’t predict where it will lead, us humans get concerned.  But all we can really do is do the business of today and be open/prepared for options tomorrow.

So, where are we?

We are not in a recession and are not on the verge of one.  The cycle is long in the tooth and we have to assume that a down-turn is in the cards.  Will it be a 2008 crash or a slow decline?  It depends on whether there is a “trigger.”  Meanwhile we could see a near-term (this summer) decline of 15% easily, and we could see a 15% rise from today’s level by early winter just as easily.   We should expect that there will be an economic and market downturn sometime in the next couple of years.  We should also expect social discontent and class finger-pointing to increase and probably lead to meaningful clashes. 

Whether the next downturn becomes a major crisis or one that gets worked out is a complete unknown.  What is known is that between demographics and the vast amount of money in the system now with nowhere to go, the prospects for any sort of return over the next decade are slim and none (so far slim hasn’t left town).

Think about this: the stock market is the same place as it was in 2014 . . . and in 2007.  With lots of volatility we have gone absolutely nowhere in 8 ½ years.  That doesn’t mean that a lot of money wasn’t made – it was both lost and made – pick your timing and timeframe.  But the upward slope to the economy and investments embedded into all of our pictures of evolution simply did not happen.   The question is whether it will resume.  The jury is still out.  

Pick your favorite belief system – Technical, Business cycle, Fundamentals, Sentiment, Demographics, Political . . . .  NONE of them show the shift to a bull/growth situation now or soon. 

Commercial real estate has continued to do as well as any sector of the economy recently.  But as was noted, without access to capital everything stops.  So, the health of the capital system is all that really counts.  We are seeing this in spades in Brazil where the capital system is essentially stopped.  Real estate and other assets are dropping in price even as the assets have long-term value.  Capital is running away from probable defaults.  The blood isn’t in the streets yet . . . .  Even in Europe the situation is not good.  When the ECB is the buyer of >50% of the debt of some countries you have to know that capital is running away from there, too.  China seems to be a similar story.

But to be clear, the best measures I have been able to find do NOT indicate that we are in or are on the verge of a recession in the U.S. now.  As to the rest of the Globe, there are enough measures to suggest that we are either at very high risk of recession or we are already in recession elsewhere.  There is some belief that the opportunities of the next cycle will be seen outside of where they were in this cycle – look to developing countries not tied to raw materials and not developed countries with aging populations and bloated political complexity.

This is not 1980 when you could look at countries as discrete entities – we are far more connected now.  What happens in Beijing or Prague, or Sao Paulo doesn’t just stay there.  If the rest of the world is stressed, we don’t get a free pass.  So either the rest of the world will turn around or we will fade, or we both will meet somewhere in the middle.  With these options, two out of three ain’t bad (Meatloaf) isn’t the answer.  The probability is that our situation will not be bullish.

Technicals – the market, region and sector charts are NOT bullish.  They have all the marks of a downward market (lower highs, lower lows) – that could change on a dime with some trigger, but we don’t know what that could be – what would be such great news that it shifts the trend to growth?  Declining does not mean that we will see 2008 again.  Think about it, if we had not had a “Lehman Moment”, the year may have gone differently.  If they would have done a Draghi “do whatever it takes”; 2008 may have been uncomfortable but not the killer it was.   I look at several charts that have had between 87% and more than 95% correlation with major market turns, one with no false positives in 50 years.  One is still hanging in with a “stay with the market”, another has dipped to sell and back to buy, but right on the edge.  All of them are on a knife’s edge but are not in full sell mode.  Thus the red flag signaling “the big one” is not waving.

Business Cycle – it is pretty clear that we are past the middle-growth stage and into the stage that usually precedes recessions.  This one is a bit confounded because of the massive amounts of excess capital looking for a home.  It is getting long in the tooth, but could go on for another couple of quarters or another three years.  Probability of shifting from where we are to full growth mode without going through a pull-back is low – never happened before, why now?

Fundamentals – where do we begin here.  EVERYTHING is down – revenues, earnings, shipments, manufacturing.  The praying continues that the consumers will all of a sudden come up with cash and spend it, but it appears that they really don’t have the cash. 

Blame the declines on oil.  But pull oil out of the numbers and they still aren’t going up.  By the way, oil is sold in dollars, and the dollar moved massively a year ago in direct correlation to oil.  The dollar pulled back over the past couple quarters, but smart minds think it is headed back up again if/as the ex-US world deteriorates – bad for oil prices.  We have seen three other price-decline scenarios in the past 50 years.  All took three years or more to work through, and we are now just short of two years from the peak in 2014.  If we have a supply hiccup (something serious in the Gulf) then oil prices will pop up – think $80 - $120, if the dollar increases and pumping continues, think $30 again.   My bet is that we will be north of $90 in two years. 

There has been a divergence between reported earnings and GAAP earnings – reported going up, GAAP going down.  The SEC has finally indicated that they will be looking into this (talk about not doing their job).  It’s like liar-loans, only this is liar-reporting. 

Sentiment – is negative.  This is usually not what we see right before a big crash.  Usually negative sentiment is a contrarian indicator suggesting a strong probability of a higher market and better times in the short to medium range.  We could see the market do a nice run-up of 10%-15% in the next 12 months.  Given all else, that may be the “blow-off top” that sometimes precedes a big drop.  Who knows.   I’m wishing for the run up. 

Demographics – any way you look at it demographics is not helping the global economic situation.  It isn’t just that populations are aging, they are actually not growing.  We may be in a better position here in the U.S. because we continue to have an in-migration of people who tend to be younger.  That ours tend to come from countries with Christian cultures yields easier assimilation.  But the demographic trend is working against us relative to the growth periods of the 1950’s-60’s when we had an influx of labor (GI’s) and the 1980’s-90’s with an influx of women providing one of the two drivers of GDP (GDP growth = Labor growth x Productivity growth).  Today this is not the case in any part of the “developed” world (read that as the countries that provide the bulk of the global GDP).  This will be a drag for decades, and the numbers are known – think about it the 20-year-olds 20 years from now already exist. 

Political – Social – it is clear that the troops are not happy, not just here in the U.S., but elsewhere as well.  We are seeing anti-government factions gaining across the globe.  We are at 80 years from the beginning of WW II, and there is a long record of 80 year cycles between catastrophic wars that re-organize the world order.  Read the book “The Fourth Turning” by Strauss and Howe, or get one of their more recent books.  Very enlightening, and actually will reduce your anxiety about the future as you see that we are progressing right on path of previous cycles – it’s out of your control, no need to fret about it, just accept the path (unless some miracle happens).   

Regarding interest rates, there is lots of jawboning about interest rates going up.  The challenge with interest rates going up is that every government in the world will be financially ruined with higher interest payments.  The charts showing the collective deficits are astounding.  On the other hand, it will be a few years down the road before the harm is felt, so probably on someone else’s watch.  But it brings to mine the words of an old rhythm and blues tune “who’s foolin’ who”? 

Now, when and how bad and what happens afterwards?  Folks, we are used to these business cycles, but given the central bank actions and the fact that they will continue to act – to do something, anything – maybe we won’t see a cycle, maybe we will see a Japan situation of 30 years of no growth, no crash, just slow decline.  We simply don’t know. 

What we do know is that there is way more money floating around than is needed, sloshing around looking for yield – causing high volatility.  Businesses don’t want it for investment in production; business investment is in consolidation of competition and numbers of shares.  But at the same time, more notional money than we all realize is tied up in places where it really can’t be used – like bank reserves and in dead debt that will never be repaid.   Which makes one wonder how much real money is in the system, money that could actually be productive.  Suck all those losses out of the system and the system and what is really left?  But nothing is going to happen until something happens – we need a trigger.  Ferdinand was the trigger for WW I, Lehman triggered 2008, you guys know better than I the triggers for the Asian crisis and other such situations.   Tell me the trigger and we will all know when the shit is going to hit the fan, from where, and how bad it might be as this cycle winds down.   

For those of us charged with investing, we can’t not be in the market, we can’t stop doing what we do.  But we do need to have our asset protection Plan B ready to implement.  Everyone thinks they will get out just in time.  History says most won’t.  Some of the big boys are describing examples right now of not enough liquidity to buy and sell positions.  In fixed asset management you have what you have when the music stops, and it is all about being able to have cash flow to cover debt.  In the public market investing some sort of hedging is prudent right about now.  We use stop losses for as much as we can, and it has made a huge difference over the past six months, just as it did when the market was going up in 2012-2014. 

Bringing it back to today.  We are not in a recession and are not on the verge of one.  The cycle is long in the tooth and we have to assume that one is in the cards in the next three years.  Will it be a 2008 crash or a slow decline?  Meanwhile we could see a near-term (this summer) decline of 15% easily, and we could see a 15% rise by early winter just as easily.   We should expect that there will be an economic and market downturn sometime in the next couple of years.  We should also expect social discontent and class finger-pointing to increase.  Whether the next downturn becomes a major crisis or one that gets worked out is a complete unknown.  What is known is that between demographics and the vast amount of money in the system now with nowhere to go, the prospects for any sort of return over the next decade are slim and none (so far slim hasn’t left town).

Branson

May 2016


At Calyx, we help families protect and manage their financial resources. We are a financial advisor and investment manager that partners with our clients to administer their financial affairs with personal attention and active risk management.

Calyx is also an advisor to several not-for-profit charitable trusts and endowments, working with committees of faith based organizations to preserve their legacy while providing operating income. We are sensitive to the investment needs of these clients while working within the guidelines they have established to reflect their principles.

Our Second Opinion Service is a free review of a family’s financial situation and portfolio. Our clients have told us that the information has been surprising and useful. This service is available for our clients, their friends, family or others around them who are unsure about their money.