The Globe and Mail, Report on Business
Published March 23, 2007

In the investment industry, I’m what people call a “bottom-up” guy. That means I get my jollies from finding undervalued businesses to invest in, rather than predicting what the market or a particular industry sector will do over the next year. That stock-picker mentality is reflected in how I manage my family’s money as well as who I’ve selected to manage Steadyhand’s mutual funds.

Having said that, I’ve always enjoyed being a student of business and market cycles. I’m not referring to the little squiggles we experience in the market we experience month to month, but the longer-running trends that have a profound impact on market returns. I’m talking about the forest, not the trees.

As a student, I haven’t developed any tools that allow me to predict the beginning or end of a long-running trend, although I have learned that nobody else has any either. There is one rule I do live by, however, and that is if a cycle has gone on for a long time and has reached extreme levels, the retrenchment period will also take time and be extreme in the other direction. Investors too often expect a short, harmless pause before the good times roll again. They are usually disappointed.

To put this in context, let’s look at the U.S. housing cycle. It’s pretty clear that the up-cycle is over, so it’s fair to ask whether the worst of the downturn is behind us, or just getting started?

Based on my simple rule, I think we’re closer to the first inning than the ninth.

The up part of the U.S. housing cycle was fueled by a number of positive factors acting in unison. These tailwinds included declining interest rates, unprecedented availability of credit, robust job growth, positive demographic and immigration trends, and a general sentiment that “if I don’t get in now, I’ll never get in.” As with all great cycles, there was a mixture of cyclical factors (i.e. interest rates, job growth) and secular factors (demographics and immigration) at work.

I believe that we’re still in the early days because not all of these factors have turned negative yet. Certainly mortgage rates have gone up a little, although they are still relatively low. Sources of credit have dried up (just try getting a high-risk mortgage today), which is negatively affecting housing demand. And while I’m not a demographic expert, I’ve got to think that the percentage of Americans that own a home, which is at an all-time high, has more chance of going down than up. On the other hand, the job situation in the U.S. is holding up well. Indeed, this down-cycle took hold while the U.S. economy was reasonably strong. If Americans start losing their jobs, or are worried they might, things could get a lot worse.

There are other factors that point to a prolonged retrenchment. As with most long-running cycles, excesses have built up, some of which will take time to unravel. In the past few years, speculators have become a big part of the mix. With little prospect of price appreciation, these players are moving from the demand side of the equation to the supply side.

Further, the use of more exotic mortgages has become commonplace in the past few years. According to CIBC World Markets Inc., interest-only mortgages in the U.S. made up 20% of all new mortgages in 2006. And half of those were variable-rate mortgages. In general, subprime mortgages accounted for 22% of originations in 2006. In Canada, where we have very little in the way of unconventional mortgage financing, these numbers are mind boggling.

Earlier I touched on the buyers’ attitude. Generally before the next up-cycle begins, we need to see a sentiment change such that buyers and investors want nothing to do with the sector. Sentiment is changing pretty fast right now, but we’ve got a long way to go on this measure.

In a long-running cycle everyone lines up in the same direction and conventional wisdom starts to reflect a continuation of current trends. That doesn’t sound so bad, but it creates problems when people riding the trend don’t know why they’re doing it, other than the fact that everyone else is making a lot of money at it. When the cycle turns, these trend chasers end up bailing out as indiscriminately as they bought in.

The point here is that when a powerful trend turns in the opposite direction, the downturn won’t be painless and it won’t end in a matter of months. U.S. housing is under the microscope today. At some point, we’ll be trying to determine how long the downturn will be for other supercycles, including commodities like copper and oil, the Chinese economy and trends like private equity.