The Big Short 2: How to bet against the Canadian real estate bubble

From Nick Rokke, Editor, The Palm Beach Daily:

“Do you realize what you just did? You just bet against the American economy.”  

That quote is from the 2015 movie The Big Short. (The movie is based off the 2010 Michael Lewis book of the same name.)

The line was uttered by the character Ben Rickert (played by Brad Pitt).

In the movie, Rickert and other securities traders used complex derivatives to short the U.S. real estate market in 2007–2008. (When investors “go short,” they profit as the price of a stock declines.)

Another of these traders was Michael Burry (portrayed by Christian Bale). Few people made more money shorting real estate than the real-life Burry.

In a time when the market was essentially flat, Burry earned over 26% per year for investors in his Scion Capital hedge fund. In less than eight years, he quintupled their money. A large portion of these returns came from his real estate short position.

If you watched the movie (or read the book), you know there’s money to be made shorting a real estate bubble.

But this time, it’s not a bet against the U.S. housing market.

The bubble is growing north of the border. And just like the American real estate bubble back in 2008, the Canadian real estate bubble looks ready to burst.

Although we can’t use complex derivatives like Burry did in The Big Short, we can make money off the Canadian bubble with a short of our own. That’s because Canadian real estate is looking a lot like the American housing bubble did a decade ago…

Housing Bubble Redux

Our northern neighbors have a housing bubble like America did in 2006… and it’s about to pop.

The run-up started in Vancouver. Over the past three years, prices had gone up 50%. Today, Vancouver real estate is tumbling…

According to the Canadian Real Estate Association, the average resale price in the Greater Vancouver area was $1.04 million in January 2016. This past January, it was only $878,000. That’s a 19% drop in prices over one year.

It’s not just Vancouver, either. A bubble is building in the Toronto real estate market. Toronto home prices were up 22% last year after being up 15% the year before.

The average selling price in January was $771,000. That’s up more than $140,000 from the previous year. We saw prices soar like that in some U.S. markets 10 years ago.

How We Know the Canadian Bubble Is About to Burst

A housing boom becomes unsustainable if real estate prices go up faster than household incomes.

That’s what happened in the United States before the housing collapse in 2007. We’re seeing the same pattern in Canada today.

The chart below shows the average home price in the U.S. and Canada and compares it to each country’s median household income.

As you can see, American home prices peaked at nearly six times higher than median household income in 2005–2007… right before the real estate crash.

Canadian home prices are now reaching that dangerous territory.

Furthermore, Canadians are more indebted than ever before… just like American homeowners were before the crash in the United States.

You can see in the chart below that household debt to disposable income is at all-time highs in Canada.

The Canadian consumer is stretched thin… even thinner than their American counterpart before the Great Recession.

When homeowners are buried in debt, they often can’t afford to pay their mortgages. We saw that in the U.S. as millions of underwater homeowners simply walked away from homes. And we’ll see it in Canada.

Just another sign this bubble is close to bursting.

The Big Short 2

Like the traders in The Big Short, we can profit by betting against Canadian real estate.

Here’s why…

Just five banks dominate Canada’s banking system. They make up 85% of the market share as defined by total assets.

In Wednesday’s Daily, we told you the top Canadian banks were already in trouble due to scandals involving shady sales tactics. They also own a large share of mortgages in the country. If the real estate bubble bursts, they could tank.

These banks are:

  • Royal Bank of Canada (RY)
  • Bank of Montreal (BMO)
  • Canadian Imperial Bank of Commerce (CM)
  • Toronto-Dominion Bank (TD)
  • Bank of Nova Scotia (BNS)

The top five Canadian banks make up more market share in their country than the top five U.S. banks do in America. If even one of them gets into trouble, it could disrupt the entire Canadian financial sector.

If you want to make a bet against the Canadian housing market, consider shorting Canada’s top five banks.

Really aggressive traders can consider buying put options. That’s the closest strategy to the one used by Burry in The Big Short. (If you don’t know what a put option is, we suggest you don’t try this strategy.)

Now, shorting stocks and buying puts can be very risky. You could lose your entire investment or more if things don’t go your way. (Options can expire worthless and you can lose more than your initial investment with a short.)

So don’t bet the mortgage on these trades. And always follow our risk-management strategy.

Regards,

Nick Rokke, CFA

Crux note: Buying put options is one way to bet against the market. But there’s another “unconventional” (and safer) way to use options to collect steady income from the markets. In fact, all you need is seven minutes to collect your first $334. Our friends over at the Palm Beach Research Group call it the “7-Minute Workday.” You can find out more about it here.

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