It's not just the value of your house that will decline if there's a serious pullback in the residential real estate market.
Parts of your investment portfolio are also vulnerable, notably banks and other financial companies with exposure to real estate. Hedge fund managers are already preparing for the possibility of a housing decline, and so is Vancouver investment adviser David LePoidevin.
"The thesis is housing slowing down – protect yourself against it," said Mr. LePoidevin, a portfolio manager who asked for it to be made clear that his views are his own and not those of his firm, National Bank Financial.
There's no clear sense of whether the housing market is right now, never mind whether we're heading toward a crash, modest pullback or renewed gains. National sales in March were down in the area of 15 per cent on a year-over-year basis, but results in the hard-hit Vancouver market for April showed a more modest dip of 6.1 per cent (other cities have yet to issue April data). Some housing bears anticipate that low mortgage rates will fuel a short-lived spring revival.
Houses are the most expensive purchase most people will ever make, so it's natural that the residential real estate market is closely watched. But housing is also an important driver of Canada's economy. Ben Rabidoux, an economic analyst who specializes in housing, said that residential and commercial construction, financial, insurance and real estate industries – combined – account for about 27 per cent of gross domestic product.
"Any time you have a run-up in house prices and debt, those industries always boom," Mr. Rabidoux said. "And then, on the lee side of that mountain, those industries always decline. Anywhere we've had a major housing boom, that's what happened."
The impact of a housing decline would also be felt in the retail industry, which has benefited from spending generated through widespread use of home equity lines of credit. When housing prices fall, people are much less comfortable borrowing against the value of their homes.
Mr. LePoidevin is protecting clients from a housing decline by using the U.S. market for 90 per cent of his equity exposure. "One of the easiest ways to protect against the cooling housing market is to simply invest outside of Canada," he said.
Another benefit of investing outside Canada is that you stand to benefit if, as Mr. LePoidevin expects, a housing decline contributes to a decline in the value of our dollar. The more our dollar falls, the bigger the boost for returns from U.S. and international markets.
Canadian financial stocks are far and away the largest sector in the S&P/TSX composite index with a weighting of about 34 per cent. Mr. LePoidevin avoids them entirely because of his concerns about the housing market. Banks operating in the United States are another matter. The U.S. housing crash is behind them, the economy is improving and they're cheap when valued using a ratio of share price to book value per share.
"I hear time and again that people like TD Bank because of its U.S. exposure," Mr. LePoidevin said. "I don't understand why people would buy TD at two times book value when you can buy Wells Fargo or JPMorgan at less than book. It's crazy."
There are three risks to the financial sector from a housing decline, Mr. Rabidoux says. One is that declining demand for mortgages, lines of credit and other borrowing will slow the brisk earnings growth that investor expect from banks. Another is that bank balance sheets take a hit from rising loan losses, and still another is a change for the worse in the global view of Canadian banks as being among the world's strongest. "We've benefited here in Canada from the perception that our banks our different, that we are a bastion of fiscal prudence."
Last week, my colleague Sean Silcoff wrote about a San Francisco-based hedge fund manager who is shorting Canadian bank stocks (betting that they will fall in price). Mr. LePoidevin is doing the same thing for his more aggressive clients.
He has chosen four financial stocks to short on the basis that they're actively traded, tied into the fortunes of the housing market and not as strong financially or geographically diversified as the big banks:
- Canadian Western Bank (CWB): Active in the four Western provinces;
- Laurentian Bank (LB): Mainly focused on the Quebec market;
- Home Capital Group (HCG): A mortgage lender through its Home Trust division;
- Genworth MI Canada (MIC): Competes with Canada Mortgage and Housing Corp. in providing insurance for lenders against mortgage default.
Look for a housing decline to have an impact on your bonds and bond funds, as well as your stocks. "The housing market is probably going to wag the bond market," said Robert Sneddon, president of the portfolio management firm CastleMoore Inc.
The negative impact of a slowing housing market on the economy could lead the Bank of Canada to lower the overnight rate, which influences short-term borrowing costs. The bond market would likely follow that cue, which means yields would fall and prices would rise (yields and prices always move inversely).
Mr. Sneddon said the best way to benefit from a rising bond market would be to look at long-term bonds (maturing in 10-plus years). These bonds are the biggest losers when rates rise, but they have the potential to perform better than short-term bonds if rates start to fall. Long bond investing options include four exchange-traded funds – the iShares DEX Long Term Bond Index Fund (XLB) and the BMO long federal, provincial and corporate bond ETFs (ZFL, ZPL and ZLC, respectively).
Commercial real estate isn't influenced by the housing market, so real estate investment trusts, or REITs, shouldn't be a concern if home prices sink. A few REITs do own rental apartments and townhouses and two of the biggest names in this group, Boardwalk (BEI.UN) and Canadian Apartment Properties (CAR.UN) have traded recently at all-time highs. "I suspect this has something to do with conditions in the Canadian residential real estate market," analyst Harry Levant of IncomeResearch.ca said in an e-mail.
Who's Big On Banks?
If the Canadian housing market were to decline sharply, the shares of banks and other financial stocks would likely take a hit. Here's a look at the financial sector weightings in popular mutual funds and exchange-traded funds. Financial stocks represent 34 per cent of the S&P/TSX composite index and they've been strong performers over the long term. It's fine to have them in your portfolio, but be careful about excessive exposure through, for example, owning both a Canadian equity mutual fund and a dividend fund.
Top 10 Canadian Equity Funds By Assets
Most Recently Disclosed
Weighting In Financials
iShares S&P/TSX 60 Index Fund (XIU)
RBC Cdn Equity
SEI Canadian Equity-O
TD Canadian Value
iShares S&P/TSX Cap Composite Index Fund (XIC)
Fidelity True North-B
Desjardins Canadian Equity Growth
BMO S&P/TSX Capped Comp Index ETF (ZCN)
TD Canadian Index
Top 10 Canadian Dividend Income Equity Funds By Assets
Most Recently Disclosed
Weighting In Financials
RBC Canadian Dividend
TD Dividend Growth
Scotia Canadian Dividend
Sentry Canadian Income
Dynamic Equity Income
PH&N Dividend Income-D
iShares S&P/TSX Preferred Share Index Fund (CPD)
RBC Canadian Equity Income
iShares Dow Jones Cda Select Dividend Index Fund (XDV)
Source: GlobeinvestorGold, company websites
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