Hope for Housing

Long-cycle theory says US and UK housing may have bottomed already...

"DO NOT overbid for assets – especially at the top of a real estate cycle," writes Dan Denning in his Daily Reckoning Australia.

You can't really argue with that, can you? The big question is, where are we in the cycle?

The opening line above came from our friend Phillip J. Anderson. He was speaking to a packed room in a building on Flinders Lane Tuesday night. Phil first came to our attention a few years ago, when one of his readers hand-delivered us a copy of his book, The Secret Life of Real Estate: How it Moves and Why.

Phil Anderson's talk Tuesday night was fascinating. It was good to get out of our lair on Fitzroy Street and hear a different perspective on the market and the world. We won't give away all of Phil's observations since the event was for paid-up readers. But if you're interested in his book or his study of historical cycles, you can check out his website.

Unlike here at The Daily Reckoning, Phil's research tells him the US and UK property markets have already made a low. If you use the past as a guide, he says:

"When bad real estate news is coupled with higher stock market lows, it's generally a bullish sign. As the stock market goes up, the productive capacity of the economy is increasing."

Phil reckons that if the Aussie stock market doesn't take out the July lows by the end of the first week of September, "it's an exceedingly bullish sign." That kind of price action in the midst of an increasingly bearish turn in sentiment would be remarkable. Phil says it would also tell you that the Global Financial Crisis is effectively over.

These are certainly not the sort of arguments were used to hearing (or making) at the DR Australia headquarters. But Phil doesn't make them lightly. And he makes a good point – students of the market's price action don't rely on opinions. The price action, he says, is "unambiguous" and the weight of money argument dictates the direction of markets.

We were impressed and even a bit sympathetic with the contrarian nature of the call. Phil even picked a day – September 7th. If new lows aren't in by then, he reckons, look out above! And though we can't go into a lot of detail here, there is an enormous amount of study of previous economic and real estate cycles that goes into Phil's forecasts. He also applies the "big picture" understanding of asset markets to his trading, buying stocks when they "break out" of a trading range.

This is somewhat counterintuitive. It requires you to buy stocks making new highs. How can something be cheap or good value if it's making new highs? But the price action is what it is. And Phil is right that understanding where you are in a cycle is crucial to figuring out whether you should be a buyer or a seller of a particular asset.

What made his talk so interesting is that the 18.6 year cycle that figures so much in his work derives, ultimately, from the value of land – the ultimate tangible asset the basis of much bank collateral. If you're into cycles, you won't be surprised to learn that Kondratieff cycles figure in Phil's work. A Kondratieff cycle is a 50-60 year cycle (or about three 18.6 year cycles) of expansion, stagnation, and recession in an economy.

The theory was based on a study done by the Russian Nickolai Kondratieff. He was asked by the communist Russian dictator Josef Stalin to study the economy and figure out when the internal contradictions of the capitalist system would cause its destruction and pave the way for the linear march of the Marxist system to worker's world paradise. When Kondratieff's work didn't show any kind of inevitable decline and fall of the West – but instead showed a cyclical process of growth and contraction – Stalin had him banished to the Gulag where he died. So much for science and dissent.

This, by the way, shows you the insidious nature of outcome-based policy making. Policy can't guarantee outcomes, which are usually driven by idealistic or naive political goals. Good policy can only guarantee that the conditions in which everyone operates are fair and equal, leaving the outcome up to your own effort, or luck, or fate, or God's will, if you prefer.

Many people study Kondratieff. Fewer understand him. And using his work as a forecasting tool is pretty tough. After all, Kondratieff's study of commodity prices was based on analysis of 19th and early 20th century commodity prices, and mostly grains at that, from what we understand. A model is only as good as the data that goes into it. So you wonder how good the data was.

Further, it's one thing for real scientists conducting experiments to use a model. But it's quite another thing for social scientists to do the same and then claim it predicts what should or must happen. This is probably our main beef with the cyclical view of history or markets. Though it makes sense and conforms to your personal experience of the world – birth, adolescence, adulthood, parenting, old age, death – it may not be true economically. Why?

Every story and every life is a kind of closed system. They each have a beginning, a middle, and an end. Some are long. Some are short. Some are memorable. Most are forgotten. But they all look like a line or a distinctive arc through time that is unique to your life.

But neither the economy nor the natural world itself are closed systems. They are not finite lines. They are infinite. This is important because it means you can never predict how an open system will ultimately behave or evolve. There's always one variable beyond your control, like the crazy Uncle at the Christmas dinner who is capable of unleashing drunken chaos at any moment or the asteroid that could crash into the Earth tomorrow.

Yet life remains constant, whether it's a cockroach or a member of the Federal Parliament (with one being a sophisticated and evolved piece of natural engineering and the other managing to be predator, parasite, and scavenger). It's odd that life endures when even geography does not. In the natural world, mountain ranges come and go.

What's more, the Earth is not a closed system. For one, energy in form of solar radiation rains down on the Earth every minute of the day, creating opportunities for all kinds of life and work. More importantly, through the genius of its un-designed design, DNA manages to replicate itself time after time and survive in many different forms. Life persists as the physical world changes.

And life doesn't just persist in the same state. It changes constantly. Nature produces an immense variety of life. The forms best adapted for the conditions which exist survive and reproduce. The rest don't. Entropy – the tendency of things to fall from order into disorder – is only defeated by life's relentless effort, through DNA, to replicate itself in as many different survivable forms as possible.

What does any of this have to do with Kondratieff and the share market?

An economy is not a closed system, either. It does not behave in a linear way. That means you can't really predict how it's going to turn out. And importing a linear or cyclical theory into a complex adaptive system like the economy means you are going to be confounded in your understanding and your forecast. You will not predict what you can't know. The unknown unknowns will get you every time.

The key variables that we do know about in any economy – land, labor, energy, and innovation – are always changing and changing the way they interact and producing new possibilities (not always good, of course). For example the role of technology in the Kondratieff cycles is, as far as we know, unexplored. When Kondratieff wrote, the industrial revolution was increasing crop yields. Human population was on the verge on productivity explosion – both physically and economically.

As people moved out of the country and into the city, so labor and capital were freed up to harness the power of coal and oil to make entirely new systems of transportation and. It really was a new frontier in terms of productive possibilities. You went from cows and washing boards to refrigerated milk and milkshakes.

By the way, these new frontiers (space, the final) always make some people nervous. These nervous people are the ones who could have the most to lose from a change in the status quo. Or, they could be genuinely and quite negatively affected by the change – the proverbial buggy whip maker watching a Model T roll down the street. Or they could be type of conservative person, psychologically and emotionally speaking, who reacts to a changing world by pining for the "old days" when things were more certain and didn't change.

This is why far right conservatives and the Greens will find they have more and more in common in coming years – both pine for a world that doesn't change much. The traditional Right defines that world in moral and religious terms. The new Left defines it in environmental and resource terms. But both are essentially backward looking and want the State to interfere in private life to keep things as they were, or as they should be again.

What the Kondratieff cycle may not accommodate is what you can never predict: the future. But at the risk of making a major ass of ourselves we'll make a prediction: the current system has been fatally compromised by the world improvers and the backward lookers. Three hundred years of improvement in the general living conditions of man are at risk.

The first major improvement in standards of living came with an increase in calories. When hunter gatherers became settled farmers, excess calories became a kind of credit humanity could spend on other things, like developing technology. With the development of industrial technology, powered by coal-fired steam engines, the next great leap came in the amount of time people had to spend growing food and the number of people required to grow it. Industrialization meant fewer people had to be employed growing food. More could be employed making things.

The variety of technology and durable and finished goods exploded in the 19th and 20th centuries. The further concentration of labor in cities made more and subtler variety possible, this time in the form of leisure and entertainment. You got the Jazz Age, Sinclair Lewis, George Bernard Shaw, the Charleston, and the Blitzkrieg. But then – and we think it started to happen in about 1914, but really picked up pace in the 1970s – we hit the limits of the frontier of this previously stable system.

With the advantage of creating money from nothing – fiat money and fractional reserve lending – a huge global credit boom accelerated the use and abuse of scarce real resources (land, labor and capital). It also accelerated the use of energy. More importantly, an already-complex system produced by a few simples rules – private property, sound money, low taxes, and free trade, the rule of law – became even more complex and fragile and stagnant as those rules were tinkered with to produce designed outcomes cherished by the political class.

Here we are today. Our prediction is that the great complexity and prosperity produced by the 19th and early 20th century is being destroyed by the tinkering and the tinkerers. They have created something that cannot sustain itself – a model of asset-based private and corporate wealth creation that is not based on sound money or honest work or the rule of law. (The corporations and the financiers and the politicians make the law to protect their interests now.)

Nature punishes the inefficient and destroys the wasteful. And so do markets, when we let them. We take the amount of surplus in the world – calories, time, leisure – for granted. In fact, we even begin to call it a right. What we forget is that all those calories and all that time and all that leisure were the by-products of a system based on simple rules. With those rules being broken, twisted, and disfigured to meet other ends, we shouldn't expect the system to produce the same kind of surplus we are used to. And now we see, it's not.

Of course without all the theory most people know intuitively that things aren't working anymore. That's because most people have already begun to adapt to a world where big institutions have trouble delivering on promises they've made and where the rules constantly change. Some people prefer not to think about this and would rather eat Cheesy Puffs instead. Woe unto them!

What we think the Kondratieff cycle doesn't show is that the history of the natural world is punctuated by extinction events – events which so radically changed the landscape or the habitat that most species didn't survive.

And in the financial world? We have seen a series of minor extinction events in the financial world beginning with the Mexican devaluation in 1995. The Asian Tigers, Russia, LTCM, the tech bubble, and then Bear Stearns, Lehman, Greece and beyond. All of these financial events are steadily concentrating risk in a smaller and smaller number of assets into which a greater and greater number of people are congregating: namely bonds and especially US bonds. This concentration is made of refugees from other bubbles that have faith that central bankers can keep a few bubbles going.

But ye of little faith, ye reckoners, what do you reckon? Will the counterfeiters running the world's central banks pull of the greatest confidence trick of all time that you can create wealth by printing money and solve a debt problem with more debt? Or will they fail?

They'll probably fail. Will it be before September 7th? Will it be in a few years? Stay tuned. And in the meantime, adapt or perish!

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