"The U.S. outlook is all about the property market, which has been the wind beneath consumers' wings this decade." Paul McCulley, Managing Director, Pimco
The world seems to be breaking down into two camps: those who, like McCulley, think housing is critical to the growth of consumer spending and believe the housing market may be in for some rough weather, although the forecasts vary greatly from a mild frost to blizzard conditions. On the other side there are those who think the housing market is in fine shape, will not be in for anything more than somewhat less growth and the American consumer will figure out a way to continue to spend more than he makes.
Put me squarely in the middle of the first group. Today we look at some of the data which continues to suggest a slowing of the housing market, and thus the economy, is in our future. This will in turn suggest that consumer spending will be under pressure. This in turn suggests that as growth in consumer spending slows a bear market in equities is a high probability outcome. We have a lot of data to sort through, but I think you will find it interesting. (This may print out longer than usual, but there are a lot of charts and graphs.)
But first, I want to once again mention that I along with my partners Altegris Investments will be hosting our third annual Strategic Investment Conference in La Jolla, California next May 18-20. The conference looks like it will soon sell out. There is limited space, so if you are thinking about attending, you should act today.
As usual, we have a powerhouse lineup of speakers. Martin Barnes of Bank Credit Analyst, Richard Russell, Louis-Vincent Gave, Mark Finn and my personal (as well as someone called Oprah's) doctor Dr. Michael Roizen (who wrote the RealAge series of books and the recent blockbuster bestseller You - The Owner's Manual). With this lineup you can expect not only solid information and some fun, but some very serious debates. One of my rules in designing a conference is to get speakers who are going to help make me a better investor and analyst. I think we have done that and more this year.
Due to regulations, we must limit attendance to "qualified" individuals and all attendees must be approved in advance. "Qualified" in this sense is a legal term which designates certain levels of net worth and not meant to say that all of my readers are not excellently qualified and astute analysts of investments and the markets. In general this means to attend you must have $2 million or more in investments, or be institutional investors. While I wish I could open up the conference to all of you, I do not make the rules. I just follow them religiously. If you are interested, click this link below to access our "Save the Date" form to allow us to contact you to help us determine if you are eligible for an invitation as soon as they are ready. If you have any questions as to whether you qualify for the event, please send me an email. Attendance is limited. The initial response has been quite strong. I suggest you act now and click on the link and give us your email address to notify you when the conference information is ready in a few weeks. https://hedge-fund-conference.com/SAVETHEDATE06.ASPX?M=1
And now, let's turn to the housing market and the health of the US consumer.
The Wind Beneath the Economy's Wings
On Thursday, housing starts came in down 7.9% after rising to a 12 year high in January. Part of this was no doubt due to the weather being great in January and bad in February. But if you look at a recent quarterly moving average, housing starts are still at nosebleed levels. And on a forward looking basis, building permits only fell 3.2%, but still at a very high 2.15 million. Permits were running at a higher level than starts in February, to give you a benchmark. As measured by permits which is one way to determine future intentions, builders are still quite optimistic.
This means homebuilders are still adding to inventory on the front end. But inventory on the backend is building as homes sales slow. This is somewhat interesting as the inventory of homes for sale is rising to new all-time highs!
I want to call your attention to a series of charts from David Rosenberg, the North American Economist for Merrill Lynch. David does very good work and I always enjoy reading him. I appreciate his balanced perspective.
Not only do we see a major rise in new home inventories, the rise from over the last year has been at the highest pace since 1984. Total homes for sale are 25% higher than this time last year, at an all-time high of 3.3 million. This is one of the reasons we are beginning to see new home sale prices actually fall slightly year over year.
Why are home supplies rising? The simple answer is that demand is falling. The University of Michigan has an index which measures the intention of people to buy a home in the near future. It is at its lowest level in 15 years. The National Association of Homebuilders Index which tracks a number of things but includes potential buying traffic in new home developments is also dropping dramatically in the last few months.
Of course, this means sales should be slowing and they are: sales for existing homes and condos are down 10% since June of last year, as you can see in the chart below. Sales for new homes are down about 5% from the peak last year, but are clearly slowing as well.
There is no secret as to the reason. Homes are simply less affordable. The National Association of Realtors tracks "First-Time Homebuyer Affordability." In 2003, the average starter home price was $144,500. As of the last quarter of 2005 it was $181,100. In just three years, new "starter" home prices have risen 25%! In fact, first time home affordability is at a 20 year low.
To qualify for a starter home today, you need an income of almost $50,000 instead of just $37,000 three years ago. And that was last year, which is the latest data I could find. It certainly is worse now as mortgage interest rates are rising.
We see the same trend in overall homes. The median price existing home has risen from $170,000 in 2003 to over $210,000 today, with the qualifying income needed rising from $38,000 to $50,000. Monthly payments likewise are rising to $1,048 from $793 just three years ago. Look at Rosenberg's next chart:
As Rosenberg notes: "This affordability index is a mean reverting series and it moves in multi-year cycles - look at how it improved from 1989 right through to 1993. So insofar as this reversion gets replicated this time around, the group you want to go long is the 35% of the population that rent - and to find out where they shop. They're the ones that are going to be sheltered by the looming housing downturn. During that 1989 to 1993 episode, income growth improved but only a little, so most of the affordability improvement came via lower interest rates and lower home prices. This time around, mortgage rates are 6%, not 10%, so declines in borrowing costs here are more limited. I don't believe we are on the precipice of an income acceleration; so it stands to reason that if this affordability ratio improves, it will be largely through adjustments on the price front. After all, average starter home prices have surged 15% in the past year and yet average family income for the first-time buyer has risen only 5%, so we have driven an unprecedented 1,000 basis point gap between the growth in the 'E' and the growth in the 'P'. This just doesn't look sustainable to me."
Housing affordability and housing prices are mean reverting. By that we mean if the actual number gets to far away from trend, either too high or too low, the number will eventually come back to the trend. If the number is too high, this can happen by prices dropping rapidly or simply going sideways for a long period of time.
As housing price increases start to slow down or even reverse(!), it will be harder and harder for consumers to justify cash out refinancing. The cash out refinancing boom was facilitated by lower rates in 2002 and 2003. You could take cash out of your home and still lower your payments. What a great thing!
Today, to take cash out will mean your payments are going to rise, unless you went brain dead in the last few years and did not refinance at a lower rate. But even so, last year saw an enormous increase in cash out financing, as consumers rushed to get on the last cheap mortgage (at least for ARMs) train out of the station. Freddie Mac reports that cash-out refinancing rose by 70% last year, but they also forecast a drop of more than 50% for this year! Look at this data from their web site:
If their forecast is correct, that means there will be over $125 billion less available for consumer spending in 2006. Now that is another 1% of GDP.
One other factor that will weigh on housing prices is a new "supply" of foreclosed homes. Many homes were sold with Adjustable Rate Mortgages in 2003 and 2004. Now, we are seeing more than $2 trillion (with a T!) of these mortgages coming up for a reset in their mortgage rates. My back of the napkin calculations suggest interest payments are going to eat up at least another $3 billion a month in consumer spending capacity over the next year. In a $12 trillion economy, this is not all that large, but it will suck almost 1/2 of 1% of consumer spending potential out of the economy.
The increase in payments should mean that we will see an increase in delinquencies and foreclosures, and that is exactly what is beginning to manifest. The Mortgage Bankers Association announced this week that delinquency rates were up in the fourth quarter from the previous quarter and year over year. It is a rising tide of payment problems.
"The increase in delinquencies is not surprising," said Doug Duncan, MBA's chief economist and senior vice president. "We have been expecting an up-tick in delinquencies due to a number of factors: the seasoning of the loan portfolio, the increased shares of the portfolio that are ARMs and subprime mortgages, as well as the elevated level of energy prices and rising interest rates."
Foreclosures weigh heavily on a market, as loan holders (mostly banks) simply look to get out from under the burden of the home. They willingly sell at a loss, depressing the prices in the neighborhood. As we have seen in many real estate downturns, this can become a spiral. Right now, it is not a major concern, as foreclosures are not all that high. But the trend bears watching, especially as we watch the ARM rate reset this year on many sub-prime mortgages.
This trend may be made worse because the number of people who own homes are at an all-time high. If you wanted to buy a home, it has certainly been made easy the past 3-4 years (which is a very good thing). But it also means that people who are still renting are doing so because they either prefer to rent or cannot afford to buy.
If a larger than normal number of homes come back on the market through foreclosures, there may not be a line of buyers ready and willing to buy the home at anywhere near the original price.
That leaves investors who will buy the home in order to rent it out. But in markets where it is much cheaper to rent a home than to buy, that means home prices will have to come back down in order to make it economical for investors to buy cheap enough to be able to get a return on their rental property.
This happened in many markets, and especially in Texas in the mid-80's. It was ugly. But for most of the country, prices simply went sideways for a period of time.
How Important is Housing to the Economy?
All of the above underscores what I wrote last January. Remember, the U.S. Census Bureau tells us that the housing industry represents over 25% of total investment dollars in the US and a 5% value of the overall economy.
I was forwarded a very interesting piece of research from Bridgewater Associates. They suggest that the impact of housing on the economy comes from three sources: the direct impact of housing activity, and "the impact of financing activity related to the housing market, and the impact of the wealth effect of rising or falling home prices. Of the three different impacts, financing activity is at the biggest extreme and is the most vulnerable, while the other two are more at cyclical highs."
"...All in all, the direct impact of housing on the economy is at high but not overly extreme levels, due to high demand for houses and the perception from people and businesses that the demand will continue and prices will continue to rise. A return to more normal activity in the housing market should lead to only about a 1.5% - 1.75% drop in direct GDP contribution over a couple of years.
"Most of the impact of housing has been through the financing of these homes, as rising prices have provided a source of cash for people to spend on all types of goods and services. The chart below shows that people are actually borrowing significantly more money than they are spending on home purchases. As an economy, the difference between these lines represents the money people have borrowed through their home mortgages but can spend on anything. Historically this has been negative as people typically do not finance 100% of their homes, but the figure has recently been growing and is positive for the last three plus years. It is now at an all time high of over $330 billion over the last year, or 2.7% of GDP."
Barry Ritholtz writes this week: "A study by former Fed Chair Alan Greenspan estimated that over $600 billion in cash out refis took place in 2004; Goldman Sachs estimated that in 2005, home owners withdrew $834 billion. The estimates are that consumers used between 50% (Greenspan) up to 68% (Goldman Sachs) of that money as discretionary spending. Over 2 years, that amounts to over a trillion dollars in consumer spending -- and THATS a number worth worrying about."
A drop in housing prices and thus activity would lead to a potential drop in GDP of at least 2-3%. (Remember, not all house refinancing would stop, nor would all housing activity, it would just slow.)
They make another very interesting point. They have a chart which shows equity, real estate and other forms of wealth as a percentage of overall wealth allocation. As you can see below, home percentages have risen and real estate has fallen, but equity (stocks and bonds) is still larger than housing.
They go on to note, "From this perspective, household exposure is still greater to equities than it is to real estate, and the volatility of equity asset values is far greater than that of real estate, so the performance of the economy and equities is likely to have more of an impact on people's saving habits than that of real estate."
Thus, if we do see a housing slowdown coupled with a poor stock market, you could see a real slowdown in the economy, which is precisely what I think will happen in the latter part of the year.
Let's go back to the quote from Paul McCulley that we started this letter with and look at the entire passage.
"The U.S. outlook is all about the property market, which has been the wind beneath consumers' wings this decade. The property market is rolling over, but at this stage we're only seeing a slowing in the market because property is a momentum-driven market with support from mortgage lenders making exotic loans and selling them to strangers in foreign lands.
"Therefore, as PIMCO's mortgage guru Scott Simon and his team have so presciently forecast over the last year, property market euphoria will not go quickly and quietly into the good night, but rather on the installment plan, with much screaming of denial.
"Collectively, we believe the end of denial is rapidly approaching. But none of us can say with confidence whether the end will come in the next three weeks, three months, or three quarters. But the end of the housing boom will come soon, we think, and when it does, sales volume in the property market will reverse wickedly. Housing prices don't crash, but volume of transactions does, as sellers refuse to face reality on pricing and buyers wait them out."
And then, from the really bad weather crowd we have the following thoughts (thanks to the Daily Reckoning):
Former Goldman Sachs investment banker John Talbott says in his new book, "Sell Now! The End of the Housing Bubble," that many Americans could be facing a 50% decline in housing prices. He estimates that America's top 40 cities will see an average 47.2% decline: Boston is 49.4%, Miami 44.8%, New York 44.6%, and Chicago 27.3%. He suggests that in the space of five years, Alan Greenspan's cheap-money policies have added $30 trillion to housing prices worldwide, an unsustainable 75% increase, he says.
And this from good friend Gary Shilling writing in Forbes:
"The current housing weakness will develop into a full-scale rout. It's clearly a bubble and is nationwide...The house price collapse will induce a painful recession that will send U.S. stocks into a tailspin...China will suffer a hard landing...and weakness in the U.S. and China will spread worldwide."
I am not quite so pessimistic. But then, I am the Muddle Through guy. Although I would think that forecasting a bear market in stocks does not exactly put me in the bull camp.
Bear Markets and Consumer Spending
Bear markets begin when growth in real consumer spending peaks and beings to slow. I think I made the case above that consumer spending is going to face a real uphill battle as cash-out financing slows down, higher energy costs don't go away, higher interest rates translate into higher mortgage and credit card payments on top of legislation requiring higher minimum payments on credit card balances.
Slower consumer spending and recessions happen "on the margin." By that I mean that consumer spending does not stop. It just slows down and maybe even stops growing on a year over year basis. That pushes profits down, which means company after company starts having earnings misses and stocks start to drop.
I have used this chart before, but it is really important. It is from "Ahead of the Curve" by Joe Ellis. You should get this book and read it. It is one of the best books out on how to predict large macro moves of the market. Order it at www.amazon.com.
You will notice that there is a very tight correlation between the S&P 500 earnings per share and consumer spending. VERY TIGHT. Right now the core P/E ratio of the S&P 500 is over 20. That is historically quite high. Real bull markets do not start from these levels. Maybe a bubble, but not a bull.
I think consumer spending is going to slow significantly later this year. History suggests that the stock market will stumble when it does. That would make the current rally a sucker's rally, or a real opportunity to make a strategic re-positioning of your portfolio.
Washington DC and Harry Browne
In one corner of my office I have the usual collection of pictures. Many of them are from political events I have been to over the years - a small collection of mementos of presidents, vice-presidents, sports figures and such. Most of the pictures on the wall are of people you would recognize. But at the top in the center is one special picture. Many visitors stare at it and then ask, "Who is he?" I answer by saying that he was a presidential candidate for the last two elections, which usually elicits a raised eyebrow. "That is Harry Browne, the candidate of the Libertarian Party." "Oh."
Harry was a special friend to many and a guiding light to the cause of true liberty. He was one of the true intellectual founders of the libertarian movement as well as a very savvy investment counselor. Sadly, he passed away a few weeks ago to Lou Gehrig's disease. It was only last year we had dinner in San Francisco and we were talking of future plans to do something together. There was no hint of anything ill.
He was a giant among men. He will be missed. Rest In Peace, Harry.
I am having to make a quick run to Washington DC on Sunday for some meetings and to see some friends, as well as do some research for the book. I am actually looking forward to the trip as I will get to see some friends I have not seen for way too long, and make some new friends as well.
I watched my daughter cheer this afternoon at the NCAA play-offs. She was really good, but alas, Memphis State was the #1 seed and showed why as they toyed with ORU. But it was fun and Dad was proud.
Have a great week. And remember to find a friend to share it with.
Your still leasing his home analyst,
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