Canadians Should Brace For A Correction

| About: CurrencyShares Canadian (FXC)

Summary

Bad economic news has overtaken good news in Canada.

Oil is a red herring; the housing market will be the real catalyst for the Canadian market crash.

Canada's mortgages have climbed to unsustainable prices at 150% above the average Canadian income.

Every day, more people are being pushed out of the housing market.

Canadians should hedge to protect their wealth; foreigners should speculate and profit from the coming bubble burst.

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When I was in graduate school, I taught children on the side to pay for expenses. One day, one of my young students asked me a question. As a bent down to look at his textbook, the child suddenly coughed in my face.

I thought nothing of it until the next day, when I began to feel a bit sick. The symptoms were like those of a standard cold - nothing too serious. But for some reason, an extra symptom was present: Every muscle in my body ached as if I had just finished a day-long weight training session.

The day afterward, the child was not in my class. I asked the owner of the school, who responded, "Oh, Max's mom just called. He's been quarantined to his home. He has the swine flu." It was the extra symptom - the muscle aches - that should have told me that I had contracted something more than a simple cold.

Economies are similar. Every bad economy has the same general symptoms - a runny nose and scratchy throat. However, the catalyst to a serious problem often comes as a unique symptom.

The US had such a symptom in the form of a real estate bubble that resulted from subprime loans distributed aimlessly. While Canada doesn't have the subprime mortgage problem that the US had, Canada does have the same symptoms that the United States had in 2008. Canada is sick, but whether that sickness is the swine flu is still pending.

For now, let's look at the symptoms of Canada's sickness. Knowledge is power, and it becomes more powerful in dire times. Canadians are increasingly exposed to bad news about the economy. A Google search over Canadian websites over the past month returns only 2,890 results for "strong economy" and 7,440 for "weak economy." Likewise, the ratio over the past year is about 1:2. The further back you go, the more this ratio becomes greater than one, implying that bad economic news has overtaken the good.

However, much of the news about the Canadian economy is mere noise. In this article, I hope to separate the noise from the symptoms that truly hint at a swine flu caliber economic catastrophe.

Please read my previous article on this topic and this video before reading what follows. (Click the image below)

Noise: Politics

The first piece of noise is invariably politics. When things go bad, humans naturally look for a person to blame in spite of the fact that blaming and problem solving are unrelated activities. In many cases, people turn to the leaders and government in charge.

In this case, we have Justin Trudeau, a prime minister that inspired young leftists with promises of legalizing marijuana and brought aboard some conservative voters by stating that his party would keep annual deficits to under $10B per year. Both of those promises were broken.

While Canadians lose their jobs as a result of pressure on the resource production industry, Syrian refugees are brought in and supplied with free housing, free food, free transportation, and free cell phones. Put it all together, and you have an easy target for blaming the recent economic problems: the Canadian government. However, this is merely noise.

The previous prime minister - from the Conservative Party - also added greatly to the deficit. Spending is a natural habit of Canadian leaders, it seems. And this spending occurs even when the Canadian stock market was strong, implying that it is not a major catalyst to a market crash.

Noise: Oil

Just as oil is noise in the United States, it is noise in Canada. Of course, oil is important to an economy, especially an economy so reliant on the exploitation of natural resources. But using oil to predict the state of an economy is absurd when oil is in oversupply.

Normally, a dearth of oil has strong economic implications, as it typically represents an "underdemand." A falling demand for oil reflects weakening industries and less transportation of people and goods. But the current "oil crisis" is not about supply but demand.

Oil does have a stronger effect on the Canadian economy than it does on the US economy, but falling oil prices alone do not lead to a market crash. If you're watching oil prices hoping to predict what comes next for Canada, you're looking in the wrong place. Like a stock market, the price of oil always rebounds; oil holds a monopoly as the only energy source for multiple industries - and it is a limited resource.

Whatever we are seeing in oil now is temporary and should not be used to look at long-term trends in the Canadian economy.

Catalyst: The Canadian Dollar

Now that we've dealt with the noise, let's talk about the catalysts to a market crash. Canada's dollar is extremely weak at present. This weakness spills over into industry and investments. At one time, the Canadian dollar was worth $1.10 USD, now it's worth about $0.70.

This is painful for Canadians who have seen their savings and investments decline on a normalized scale. Canadians who were smart enough or lucky enough to quickly see the decline in the loonie reduced their exposure to the Canadian dollar, investing in outside markets. And such investments will continue to take place as Canadians increasingly wake up to a lower loonie.

More painful is the fact that real wages have not changed in Canada while real prices have soared. With the S&P cutting its growth outlook on Canada partly because of the falling incomes of working Canadians, the outlook is not good. Job growth, previously estimated to be up 5,500 in January, actually came out as a reduction of over 5,500. Realize that job growth is a lagging indicator; a bear market might already be looming.

The middle class is being squeezed. Food prices are on the rise, as are car prices, networking prices, and - most importantly for this conversation - house prices.

Catalyst: The Housing Market

This is the meat of our discussion and why I chose to write this article. I am of the belief that human institutions are all alike. The so-called cultural differences that we see in some are a matter of time, not embedded racial or social differences.

Being so, some countries are behind others in many respects. You only need to look at practically every industry in China to see a mimicking of industry development that once occurred in the West. Likewise, certain economies and markets can tell us the futures of others.

Personally, I see Japan as the future for most developed nations. Japan is ahead of the United States by roughly 15 years, by my estimate. So, Americans can brush up on Japanese economic history to predict the future.

On that note, Canada is roughly 10 years behind the US. I know the way I'm phrasing this might be polarizing - no one wants to hear that their country is "behind" another. But I say this with no negative or positive connotation - just that we see the same trends in certain countries as lagging behind the trends in others.

The Canadian housing market escaped the US real estate bubble but not the subsequent economic meltdown. Similarly, the US escaped the Japanese real estate bubble but not the meltdown. No matter how a bubble pops, it eventually pops if it is a bubble; the method is secondary.

The Canadian real estate market is seeing a bubble of America's 2008 caliber. While the real estate bubble is not a new phrase to Canadians, it is relatively new in the scope of things, only being on the lips of Canucks for the past couple of years. In fact, the data shows that a correction in the real estate market is way overdue.

Canadian home prices have been on the rise throughout the 21st century, only taking a slight dip to the tune of 7% in 2008. Home prices almost immediately bounced back, now nearly 4 times as expensive as they were at the beginning of the century:

Compare this to US house prices being corrected by nearly 30%:

(Source: ICIS.com)

Besides house prices, other statistics fell to more stable levels in the post-2008 United States. Take debt-to-income, for example. Comparing that of the United States to that of Canada shows Canada to have climbed to unmanageable levels, with mortgages being priced at 150% the average person's income:

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(Source: Stephen Gordon, Macleans.ca)

Clearly, this is an unsustainable trend. You might be tempted to say that the US market was different because of the few restrictions on who could successfully obtain a mortgage. But regardless of rules, a 150% DTI is alarming.

This is a debt bubble as much as it is a real estate bubble. With jobs being lost, ultimately not all the debt will be repaid. One likely result is a cascading effect a la 2008 USA in which we see a series of defaults, bringing down the real estate market and the stock market with it.

Anyone with a DTI of over 100% must be leveraging. Many of those taking out mortgages cannot actually afford to repay them. Essentially, Canada is painting a picture that resembles the same the US painted in late 2007.

But there's more: The crash of a real estate market will begin a vicious cycle. The housing construction industry will also take a hit. Nearly 10% of Canadians are employed in this sector, compared with 5% in the US at the time of the real estate crash.

While some analysts claim that the Canadian real estate crash would be less drastic than the US version, I disagree for this very reason. I believe the cyclical nature will be exacerbated. Defaulting and a lack of demand in housing beget a lack of demand for workers, which in turn begets less income for the middle class, thereby begetting more defaulting on debt payments, restarting the cycle.

The United States has recovered in the real estate industry, while Canada is diving head first into the US's past. But don't trust me. Let the data do the talking:

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The above shows the prices of real estate versus the average income. After the 2008 crash, homes in the United States became fairly priced and now sits at a stable level. Notably, the real estate market in the US is healthier than that in Japan, which simply declined since its bubble; Canada however is at previously unseen rates, even compared to 2008 America.

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Prices in real terms show this exacerbated.

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In regards to rent, we find another catalyst that will lead to an eventual bubble bursting. Whereas in Japan, buying a home is the economically sound choice, in Canada it's renting. This will further push people out of the housing market and discourage younger people from buying homes.

In addition, landlords will find it harder to justify buying property as an income source. Perhaps the future of homes of Canadians will look like that of the Chinese: multigenerational. In any case, the end result is less overall demand for new homes, further hurting both the real estate market and the construction market.

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In the long term, Canada's home prices have increased the most.

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The 2008 "correction" shows that US homes lost roughly half of their growth. If the United States is Canada's time machine, Canadians should brace for a similar correction. But how?

How to Prepare

Hedge against these factors. If you are American, bet against the loonie and Canada's economy by shorting (or buying puts) on the CurrencyShares Canadian Dollar Trust (NYSEARCA:FXC) and iShares MSCI Canada ETF (NYSEARCA:EWC), respectively. If you are Canadian, buy the Horizons US Dollar Currency ETF (DLR.TO) and iShares MSCI USA Minimum Volatility ETF (XMU.TO).

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.