The flow of the cycle

The trough of the average 18-year cycle bottoms out as credit conditions ease. The first to low will be the stock market, which, once it does so, will then quickly price in the assured easier credit conditions to follow.

Stock Market 1991
Stock Market 1975
Stock Market 1955
Stock Market 1933
Stock Market 1914
Stock Market 1896
Stock Market 1879

This can be picked up early in the stock market when continued bad economic news brings higher lows in the market, not lower lows. Recovery is quicker these days than several cycles ago as Reserve Banks world wide find alternative strategies to ensure formerly mortgaged and foreclosed real estate does not flood the market all at once.

Available credit is the key. It is usually suggested to follow the money, but why does the money flow to where it flows ? It follows the rent mostly, the gain for the least amount of effort.

Residential real estate will recover first from the downturn. This is not something that just happened this current cycle, after 1991. Roy Wenzlick had already noted the phenomenon and reported it in 1947:"Historically, office building construction has always taken place toward the tail end of the big real estate booms of the past. In the first part of a real estate boom the great activity is always in residential properties. Only after the boom has continued over a period of years do space stringencies develop in the office building field, with rapidly rising rents. Even then leases delay the rise. By the time that net income becomes high in relationship to construction costs, the boom is near its end." (The Real Estate Analyst, Vol XVI, Number 53, November 29, 1947, page 443.)

The real estate cycles since then have, of course, unfolded in exactly the manner in which Wenzlick described; residential prices recover first, commercial prices towards the end.

A feature of the recovery process, in the past, the US federal government found new ways in which to give away its acquired lands. These days, since the land is now fully enclosed, banks have developed ways to offload the risk and pass on their foreclosed real estate without depressing prices greatly.

4 or 5 years in, nervous recovery gives way to confidence among buyers that good times are not far away. Soon, a boom is back. By this time, banks are aggressively seeking persons with whom to do business and make available credit. Credit growth surges.

Economist Milton Friedman made a study of money and credit years ago and published the details in his book A Monetary History of The United States, 1867 1960. Some relevant charts are reproduced here to show that growth. It is interesting to note how Friedman chose to break up his credit history into phases, 1867-1879, 1879-1897, 1897-1914, 1914-1933 illustrating the growth and contraction of credit, as it turns out defined by the more serious downturns. The dates should be familiar.

Credit Growth 1958 - 2006
Credit Growth 1914 - 1933
Credit Growth 1897 - 1914
Credit Growth 1879 - 1897
Credit Growth 1867 - 1879

7 to 9 years in, a slowdown develops, we came to identify this within the historical chapters as our mid-cycle slowdown, or recession. The downturn does not usually involve real estate, with land prices usually continuing to move higher by the time the recession is over. Especially these days after interest rates are deliberately lowered as a strategy to move out of such recession. After that, the public will turn en-masse to investing in real estate. It never goes down, they will be told. Stories will surface of the huge returns some investors have made, attracting even more opportunists to this activity. In the past, this was described when 'greengrocers and servent girls' took to land speculation. By 1929, the expression was 'bootblacks and waiters'; in the late (nineteen) eighties, house painters and office girls. Perhaps this time we might watch for professional athletes and actors expressing their 'faith' in the real estate market and professing all manner of advice.

Eleven to twelve years in, tall buildings start to appear; competition to build them starts in earnest. A sure sign that credit is now really easy to get since commercial skyscrapers are mostly built with other people's money. Site owners start to complain that their property tax bills are 'destoying' business. Ostentatious displays of wealth will now be lauded. Everyone will aspire to be one of the new wealthy. Travel programs and real estate shows have long since replaced the endless comedy sit-coms that dominated the airwaves when economic times were at their most severe.

This illusion of wealth is all-pervasive, and will be reinforced as the US stock market crosses the old highs made during the previous decade cycle. In all past 18-year cycles for which there is data, the stock market has done this taken out the tops made in the prior decade before the mid cycle slowdown. It has happened again in 2006. (Take another look at the stock market gifs linked above.) Underneath however, the economy will be under increasing stress, built as it is upon credit, created by banks out of nothing, mortgaged upon the price of those government granted licenses, the largest of which is land value. A bank's profit is geared to its lending, so at any given time, they will always be seeking to be "fully loaned-up", as historian Murray Rothbard pointed out. (A History of Money and Banking in the United States: The Colonial Era to World War II, page 143.) By that he explains further that he means: "to expand as much as is legally possible up to the limits imposed by the legal reserve ratio."

Until, that is, their fear overtakes their greed.

Into the very final years of the cycle, the point at which things will most likely appear at their rosiest, an event will take place to create doubt in the minds of investors. The event at the time may be rather trivial and may or may not be credit related. But it is enough to start a few people selling. Then there will be another event that creates a real crisis in confidence. Such an event, to create a real crisis, can only be finance / bank / credit related, and takes everybody by suprise. It shows the economy for what it is, heavily mired in debt. The rush for liquidity is not far behind. We might note though, usually there can be a number of false downturns (in confidence) in the lead up to the final top, worries that the stock market will continue to climb above by setting record new highs. This is indeed how we should know that they are still false downturns in confidence.

Significantly, land price must also have climbed high enough to threaten the banking sector's loan book built upon this value. For the real estate cycle, land price is the indicator to watch, noting that the peak in land values is reached 12 to 24 (even perhaps as long as 36) months before the recession. As history teaches us.

The crisis is always amidst an environment of rising interest rates.

Rate increases into 1991
Rate increases into 1955, 1929
Rate increases into 1929, 1914
Rate increases into 1893
Rate increases into 1873
Rate increases into 1857

Businesses having expanding exponentially on debt, will be the quickest to fall. The banks most exposed to real estate are the first to reveal their 'problem' loans. It might be noted that in this regard, the Fed is part of the problem, not the solution. (1974, the Franklin bank trauma, the 1980's action by Fed president Volcker worsening the problem of the thrifts, to mention just two.) The thing to watch in a bank; heavy reliance on very short-term borrowings to finance long term loans, a banking problem that is solvable only until land price collapses.

List of past 'events' that confirmed the turning of the cycle.

So in the lead up to the final few years of this cycle, observe which credit creation institutions are significantly increasing their risk profile and exposure to real estate lending, right at the end of the 18 year cycle. Indeed, as the banker's own bank, the Bank for International Settlements (BIS) itself noted as part of the conclusions into its study of banking failures: "the widespread banking crises that involved credit risk were remarkably similar. A period of financial deregulation resulted in rapid growth in lending, particularly in real estate related lending, rapidly rising real estate prices encourage more lending, abetted by lax regulatory systems in many cases. When economic recessions occrred, inflated real estate prices collapsed, leading directly to the failures." (Bank Failures in Mature Economies, BIS, 2004.) The end to the current cycle, whenever it comes, will not prove any different this time, than last time.

At a real estate cycle led peak, as has almost always been the case historically, the ruling administration is usually preoccupied with other issues. This has a tendency to also focus the public mind on such issues, most of whom will then simply not be able to see all the subtle signs of impending downturn.

It really has all been said before:

"Every great crisis reveals the excessive speculations of many houses which no one before suspected." Walter Baghot, explaining banking in his book of the early 1800's.

"At any time there exists an inventory of undiscovered embezzlement in - or more precisely not in - the country's businesses and banks. This inventory - it should perhaps be called the bezzle - amounts at any moment to many millions of dollars." John Kenneth Galbraith, The Great Crash of 1929, published 1955.


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