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Canadian Housing: The Next Big Bear Market?

A number of major institutions, including the International Monetary Fund, have recently warned about the risks of an overvalued Canadian housing market. The latest to add its voice to the chorus was the Bank of Canada, which estimates prices of residential properties to be 10-30% overvalued.

However, overvaluation can continue for a long period of time and is not normally a sufficient condition for a market correction. Let’s take a look at possible triggers for a correction in housing prices and some companies to avoid should it happen.

Are we facing a bubble in the Canadian housing market?

Charles Kindleberger, describes in his famous book Manias, Panics and Crashes the typical events leading to a bubble and eventually to a crash in financial asset prices. Here is a short summary.

The chain of events leading to a bubble is normally initiated by an exogenous event (like super low interest rates for an extended period or abnormally high oil prices) creating opportunities for profit. At this point banks and other lenders get involved with aggressive lending, leading to further price increases and speculation which develops its own momentum and culminate in investor “euphoria”.

Eventually asset prices become removed from realistic values, prompting nimble investors to take profits and sell out. Prices start to level off, convincing more investors to leave the scene. That leads to further price declines, possibly accompanied by the financial failure of a high profile lender or leveraged investor or the revelation of large scale fraudulent activity. Further prices declines may result in a stampede to exit often leading to disorderly liquidation.

A full analysis of the Canadian housing market conditions against the Kindleberger template would take more space than I have here, but it is probably fair to say that a number of corresponding “bubble” conditions are evident in the housing market especially in the regional hot spots of Toronto, Calgary, and Vancouver.

Which factors can trigger a correction?

Two exogenous factors that have positively impacted the demand for housing over the past few years, namely low interest rates and high commodity prices, may not be supporting factors for much longer.

Commodity prices and production, which influence a sizable proportion of the Canadian economy, have been in decline for some time now. This is well illustrated by the Bank of Canada commodity price index, weighted according to 24 Canadian produced commodities, which has declined by 28% over the past six months. Apart from oil, other commodity prices such as precious metals and coal are also in a declining phase. Lower commodity prices will eventually impact employment and income with a negative outcome for housing demand.

Mortgage rates are key determinants of housing affordability and demand and although there are few signs that interest rates will rise any time soon, it will eventually normalize. A simple illustration – for a 1% increase in mortgage rates from current levels, the monthly payment on a loan, amortized over 25 years, will increase by 11%. Home buyers and speculators will anticipate interest rate movements well in advance and adjust their behavior accordingly.

Companies to avoid if the correction happens

The obvious stocks to avoid during a house market correction are the pure mortgage lenders such as Home Capital Group Inc (TSX: HCG), mortgage insurers such as Genworth MI Canada Inc (TSX: MIC) and real estate investment trusts focused on multi-family housing such as Boardwalk REIT (TSX: BEI.UN) and Canadian Apartment Properties REIT (TSX: CAR.UN).

Although the large Canadian banks are better diversified with a variety of income streams and fairly conservative and well protected home loan books, all will be impacted by a sharp correction in the housing market. However, banks without a meaningful international profit center and with large portions of their loan books extended into the domestic housing market such as Canadian Imperial Bank of Commerce (TSX: CM)(NYSE: CM) and National Bank of Canada (TSX: NA) will probably be impacted most by such a correction.

A sharp correction in the Canadian housing market will impact a range of local companies. Be sure to diversify your portfolio with 3 U.S. stocks EVERY Canadian should own.

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Fool contributor Deon Vernooy, CFA has no position in any stocks mentioned.

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