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Is The Canadian Housing Market Bad for Canadian Banks?

By Jason Pearce

Prices in the North Could Head South

Everybody loves a good market bubble story!  If that’s you, you’re in luck because it looks like we may have one in play just over the border.  Although it doesn’t grab all the headlines here in the US, the housing market up in Canada is certainly a hot topic.

There are some analysts who liken the current Canadian housing market situation to that of the US housing market a little over a decade ago.  That’s not entirely accurate, though.  Don’t expect to see a foreign version of The Big Short in theaters anytime soon.

On the other hand, there are enough parallels between the US housing market demise and the current situation in the Canadian housing market that that one has to wonder if a major shakeup is imminent.

To the Moon

We all remember how ridiculous the housing prices got when the bubble in the US peaked in 2005.  But did you know that Canadian housing prices experienced a run-up, too?  Even better, the Canadian market did not collapse when ours did.  It stayed elevated until 2007 before the financial crisis finally pulled the rug out from under everything.

Fast forward to a few years later and the Canadian housing market has fully recovered.  It surpassed the prior peak by a country mile.  Here’s the real kicker: Canadian housing prices have exceeded the 2005 US housing prices by a large margin!

 

Some might immediately think that the higher price reflects the exchange rate.  The Canadian dollar is significantly lower than the US dollar, so Canadian houses should naturally show a higher price tag.  But when you compare the average house prices for Canada and the U.S. with both denominated in U.S. dollars, it reveals just how expensive the Canadian housing market is.  It has surpassed the U.S. bubble’s peak.

 

Adjusted for inflation, not only has the Canadian housing market blown past the peak of the US housing bubble, but it has now matched the real estate bubble of Japan from the 1980s.  That certainly didn’t end well.

The Lead Sled Dogs

Vancouver and Toronto are the two Canadian markets leading the charge in this housing bubble.  Their price gains out-paced the rest of the country.  So you can’t say that someplace like Ottawa is just as frothy as Toronto.  However, these top growth markets are still having an impact on the entire Canadian housing market.

 

To get a feel for how far things have gone, compare the Vancouver and Toronto markets to places like Miami or San Francisco during the US housing bubble.  You quickly surmise that these two Canadian cities have outperformed the cities that led the charge during the US boom.

The Bigger They Are…

Since Vancouver and Toronto went up more than the rest of the metro areas, it stands to reason that they should also go down the most.  But that does not mean the other areas will not also go down decline.

But it is possible that the negative psychological effect of a falling housing market could increase the rate that other metro areas go down with Vancouver and Toronto.

What we are talking about here is beta.  For example, if one metro area went up 50% as much as Vancouver and Toronto, we’d say it has a beta of 0.5.  But what if the beta increases to 0.6 or 0.7 during a decline?  It would mean declines of 60% or 70% as much as Vancouver and Toronto.  It’s certainly not a guarantee that we would see a beta increase, but you can’t rule it out either.

No Subprime Crisis

One major difference between the US housing bubble and the current Canadian housing market is that Canada doesn’t have a major chunk of the real estate market tied up in subprime garbage.  The higher lending standards of the Canadian banks are the whole reason that they didn’t suffer the same fate as the US when the last housing bubble popped.

 

Currently, subprime loans make up about 5% of all mortgages issued in Canada.  When the crisis hit the US market, roughly 21% of all U.S. mortgages were subprime.  Therefore, the Canadian housing market is not quite as risky as the US housing market was a little over a decade ago.

But notice that I did not say that the Canadian housing market is risk free.

Home Owners Are Stretched

Predicting where a bubble will peak is a tough business.  But you can get a sense of how mature the run is when the buying capacity is stretched.  When there’s no one left to buy, there’s no more upside for the market.

 

Right now, buying capacity is spread pretty thin.  The Canadian household debt-to-income ratio is well beyond what it was at the 2007 peak.  Ominously, the Canadian household debt-to-income ratio of nearly 170% is getting awfully close to where the US household debt-to-income ratio peaked during the US housing bubble.

The household debt-to-income ratio does not take mortgage fraud into account, either.  Lending agency Equifax Canada reported that the number of “suspicious” mortgages have increased 52% over the last three years.  With two-thirds of the mortgages in Ontario flagged as “suspicious” it is conceivable that households are stretched even further than the official numbers state.

Wheels Set In Motion

The housing market may have finally peaked as the government took action to douse the speculative frenzy.  Last summer, British Columbia passed a law to make foreign buyers of Vancouver real estate pay a 15% tax.   Furthermore, the federal government changed the rules for all insured mortgages that make it more difficult for buyers to qualify.

 

Not surprisingly, the changes in Vancouver had a major impact on the market.  Over the last 12 months, home sales have plunged 40 percent and home prices have started softening as well.

The Next Shoe

Ontario has yet to reign in the out-of-control housing market.  Therefore, prices in Toronto are up nearly 23% from a year ago and supply is only half of what it was then.  Ironically, experts are saying that the crisis is actually the shortage of supply!

Despite the supply shortage, you have to wonder how much more housing prices can increase if there is not a corresponding increase in the buyer’s income.  As we’ve already seen, buyers are already stretched thin with a household debt-to-income ratio that rivals that of the US household debt-to-income ratio at the peak of the housing bubble.

History Repeats

When the Toronto housing market bubble finally pops, it won’t be a new experience for homeowners.  If history is any guide, it will not be a pleasant event.

Toronto housing prices peaked in 1958, softened for years, and finally bottomed out in 1964.  In 1966, prices finally returned to the 1958 peak.  That was an eight-year round trip.

The next major top occurred in 1974.  Housing went into an eleven year bear market and posted the final low in 1985.  It wasn’t until 1987 when the housing market finally matched the prior peak.  That’s a thirteen-year wait to breakeven for Canadian homeowners who bought in 1974.

The rebound off the 1985 low turned into a full-blown bubble.  It finally popped in 1989 and began a multi-year decline that didn’t end until 1996.  Adjusted for inflation, this decline knocked a whopping 40% off the housing prices.  Furthermore, it took a little over twenty years for the Toronto housing market to return to the 1989 peak.

 

Adjusted for inflation, current Toronto housing prices are substantially higher than where the last bubble peaked.  If history were to repeat, this will be followed by a multi-year bear market.  Investors who believe that “It’s different this time” are in for a rude awakening.

Nothing to Worry About

Logically, more housing market price gains similar to what has already occurred are economically unsustainable.  Besides, the housing market in Vancouver –one of the leaders in this bubble- is already slowing down significantly.

Despite these facts, there still isn’t much concern for the potential downside.  When people aren’t prepared for an adverse an event, that’s when they are the most vulnerable.

 

For example, while saying that the Canadian housing market growth may slow down, Moody’s Analytics said nothing about the growth actually stopping or even reversing.  Their big warning is that national house price growth will drop to from about 8% right now to about 2% by the end of 2018.

This is unsettling.  It reminds of the summer of 2005 when Ben Bernanke, the Chairman of the Council of Economic Advisers, said,” Housing prices are up quite a bit; I think it’s important to note that fundamentals are also very strong. We’ve got a growing economy, jobs, incomes. We’ve got very low mortgage rates. We’ve got demographics supporting housing growth. We’ve got restricted supply in some places. So it’s certainly understandable that prices would go up some. I don’t know whether prices are exactly where they should be, but I think it’s fair to say that much of what’s happened is supported by the strength of the economy.”

 

Then in February 2006 when he was the new Fed chairman, Bernanke said, “The housing market has been very strong for the past few years . . . . It seems to be the case, there are some straws in the wind, that housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise, but not at the pace that they had been rising. So we expect the housing market to cool, but not to change very sharply.”

So much for the assuring words of the experts…

More Potential Catalysts

We already covered the reasons that the Canadian housing market bubble may have started to deflate.  Heck, it could even pop.  But what we did not get into are the other potential events that could raze the Canadian housing market.

What if the bull market in stocks pauses or even comes to an end?  Household wealth levels would decline.  Home values would likely get dragged down with it.

Canada is a big-time commodity producer.  Another break in the price of crude oil, gold, or the grain markets would have an adverse effect on Canada’s economy.  Housing markets would likely feel the impact.

If Ontario finally wakes up to the danger of the housing market bubble and changes the rules like BC did, we should expect the same outcome: a drop in both home sales and home prices.

 

What if the economy, the stock market, and commodities all stay strong and the boom times last?  Eventually, that could drive the Bank of Canada to decide that tighter monetary policy makes sense.  An increase in interest rates could become the proverbial straw that breaks the camel’s back.

How to Play It

It’s not like a trader or investor can “go short” on a Toronto condo or a Vancouver house.  And although the CME has futures contracts on major US cities like Miami, San Francisco, New York, Las Vegas, etc. there currently aren’t any for Canadian cities.  But perhaps one way to trade a decline in the Canadian housing market is to short their banks.

Right now, this may sound crazy.  Moody’s Investor Service says the Canadian banks would perform better in a housing market downturn than the US banks did.  The big Canadian banks have been around forever.  They have weathered the prior financial crises and came out on the other side.  Furthermore, they pay generous dividends and most of them have recently reported increased income.  What investor would want to sell their shares in a bank with such a great track record?

But that doesn’t mean that they haven’t experienced setbacks.  And it sure doesn’t mean that they won’t in the future.

According to the Toronto Stock Exchange, Canada’s banks are already being heavily shorted right now and in a much bigger way than similar-sized companies.  But according to the stock price of these banks, the short positions have been mostly wrong for months.  Why?  Because the price has been trending higher for months.

Trend Change Afoot

Despite the case for the Canadian housing bubble to pop, a trader should look for price confirmation before acting on any theories.  This is that timing part of the equation.

Right now, we may be finally getting that confirmation as many Canadian bank stocks have started to deteriorate over the last couple of weeks.

 

First off, some of the banks stocks may be establishing a classic Double Top pattern by trading within pennies of their prior highs and then stating to pullback.  Royal Bank of Canada (RY) and Bank of Montreal (BMO) both fit this bill as they neared the 2014 record highs and retreated.

 

Both of these stocks are now dangling just above technical support between their rising 50-day Moving Average and last month’s low.  A close below the 50-day MA and a break of a prior month’s low –neither of which have happened since November- could put further pressure on the stocks and drive it down to the widely-watched 200-day Moving Averages.  This could increase the odds that a major top is in place.

 

Toronto Dominion (TD) is even more intriguing.  This stock surpassed the 2014 record high by nearly $1-per-share and then pulled back sharply.  This is what I have coined the Wash & Rinse sell pattern.  By definition, this is a failed breakout pattern where a prior high is surpassed and then the market quickly reverses lower.  The Wash & Rinse can often lead to major declines.

 

Furthermore, Toronto Dominion got crushed on Friday as it dropped 5.31% and broke the rising 50-day Moving Average for the first time in five months.  The stock also plunged below a prior month’s low for the first time in nine months.  Ideally, a bounce back to last month’s low or the 50-day MA (old support, once it is broken, becomes new resistance) would materialize and allow for a nice entry point.  If successful, the position size could be increased aggressively if new corrective lows follow.

 

Finally, there are a couple of stocks that never got close to their prior highs.  They become short sale candidates by virtue of comparative weakness.  They are the worst-performing of the bunch and vulnerable to getting hit the hardest.  Bank of Nova Scotia (BNS) and CIBC (CM) are the two that I am talking about.  Is it any coincidence that CIBC has the highest real estate exposure and it’s one of the worst looking Canadian bank stocks?!

 

Bank of Nova Scotia already cracked support at the 50-day Moving Average and prior month’s low, while CIBC has not.  This means that Bank of Nova Scotia is currently more qualified for a short sale than CIBC.  Once CIBC has violated these same technical levels, it will show that it is also ripe for the picking.

Be Smart

Sometimes, traders think they’ve found the once-on-a-lifetime trading opportunity.  One that’s almost a sure thing.  One that could create the kind of fortune that lasts for generations.  Maybe shorting Canadian banks will be the most talked about trade next year and you’ll hear all the stories of the next John Paulson’s of Canada who made billions of dollars betting on it.

If you get into a trade and it starts to go your way, great!  You can short even more Canadian bank stocks if they keep dropping and your current positions are all showing open profits.  The winners take care of themselves so we don’t need to go too deep into a detailed discussion.

The problem, however, is that we could always be early.  Worse yet, we could even be completely wrong.  One never knows that a trading opportunity is a sure thing until it has gone on the record books as a matter of history.

How many people were shorting European bonds once the yields dropped to near zero percent?  Here we are a few years later and yields are now negative.  Although it seemed like a no-brainer at the time to bet on rising yields, it was completely wrong.  A lot of good traders broke their axe on that stone.

 

So do the smart thing and focus on managing your risk.  This should be your top priority.  There’s a great Wall saying, “Bulls make money, bears make money, but pigs get slaughtered.”  Don’t ever bet the farm on any trade idea and don’t add to a losing position.  As a matter of fact, the only thing you should do with a losing position is liquidate it.

 

 

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