House Money, Part II
"You have to begin to sell when the householder buys." Attributed to one of the Rothschilds
The Fed chairman seemed proud of his work. Speaking to Congress last week, he said that interest rates, driven down to below-market levels by the central bank, had encouraged "households to purchase homes, refinance debt and lower debt service burdens, and extract equity from homes to finance expenditures."
American households took Mr. Greenspan’s bait. They took whatever money they had on hand, borrowed more from over-eager lenders, and bought what are usually charmless, flimsy, pathetic, sordid, puerile suburban homes. A few of the more aggressive householders began buying and selling them as if they were dot.com stocks. Now, they have plenty of house, not much cash, and they’re on the hook for $2.7 trillion in mortgage debt. What will they want next? More split foyers? More colonials? Ranch, contemporary, Spanish colonial? A McMansion?
Or more cash and less debt?
The average American lives in a suburban house thought to be worth $192,400. Since stocks began to decline nearly 3 years ago, his net worth has not necessarily declined, but it has become less abstract; the poor man now has to live in it. Worse, if things develop as we fear, he’ll have to live in it for a lot longer.
But for now, he is as content with himself as the nation’s Fed chief. His "investment" in his house has done well – far better than an equivalent in the stock market. He does not notice that his castle of 2002 has no moat to protect it from a bear market in housing.
The Daily Reckoning is free. Since you pay nothing for it, we feel entitled to pass along our gratuitous reflections; sometimes readers find more of them in their morning’s DR than in the bathroom mirror.
Readers write almost daily, asking to be taken off our list. Irish, gypsies, gay, straight, Republican, Democrat, frogs – who have we not offended? Tomorrow, we fear…we will hear from the suburbanophiles.
"Single-family homes are selling quickly, prices are soaring, and buyers who square off in bidding wars can end up paying thousands more than sellers have asked for," says the Philadelphia Enquirer.
"Why the frenzy? Low interest rates are the most obvious cause. When rates are low, buyers can qualify for bigger loans, so they can afford to bid higher. Though rates have been low for two years, many people may be rushing to buy now for fear that rates will rise as the economic recovery progresses.
"But they have another reason to rush: fear that rising property prices will put their dream homes out of reach, even if interest rates stay low. This overeagerness to buy is a classic sign of a bubble."
A housing bubble in Philadelphia? It seems almost impossible. Who would want to buy a house in Philadelphia…must less at a premium? But house prices are up in Philadelphia, and even some parts of Baltimore. My sister, looking around rural Virginia, reports that there too it is a seller’s market – even in the most benighted areas.
"The five most expensive markets in the nation in order are Boston, where the percentage of income devoted to mortgage payment is 44.9%, San Diego at 43.1%, Fort Lauderdale 29.1%, San Francisco at 47% and Miami at 30.0%.," adds Richard Russell.
"The old rule was that you spend 25% of your income either on rent or for carrying your mortgage. All of these cities are above 30%. This is just one test of housing prices, but I think it’s valid. And yes, I do think housing is in a bubble."
When the Nasdaq bubble popped, dot.com analysts moved on – to making real estate appraisals. Thanks partly to their accommodating estimates, suburban America is now thought to be worth about 15% more than it was last year at this time…and twice what it was worth in 1990.
This newfound "house money" has sheltered Americans from the decline in stocks. While stocks lost about $5 trillion since the top, real estate is up about the same amount. Our question in this letter is how much longer this house money will hold up. Our answer, as on Wednesday, is "not much."
A poster on Richard Russell’s site: "As a student of bubbles and crashes (am an investment professional who has spent his career in emerging markets), I can tell you that I have never seen a bubble in equities unwound without an unwind in property. For example, Japan, Korea, Hong Kong, the Philippines, Thailand, Indonesia, Mexico, and Brazil. And the unwind generally begins when credit goes south, which happens shortly after an overvalued currency begins to fall, which follows the first leg down of a big, ugly bear market."
Why can’t residential real estate just continue to rise – even after stocks head down?
John Mauldin explains:
"If homes were to rise in value by just 7% per year (forget about 10%), in ten years that means the value of our homes would double. If incomes were to grow at 3% per year, the portion that we allocate to housing would have to rise by 50% to be able to buy the same house."
It is all very well for the seller. He watches the supposed value of his house rise up like a drunk from the floor of a saloon. For a brief moment, he imagines himself rich…and begins to daydream about the marvelous retirement in the sun he will enjoy on the proceeds of the sale.
But to whom will he sell? With incomes rising at only half the rate (in John’s example) who will be able to buy the house at the list price?
And…who would want to?
More to come on Monday…"The Crash of Suburbia and the Coming Depression."
August 19, 2002
Oh la la…another bad day on Wall Street. Mr. Bear just won’t let up.
We have a feeling…just a feeling, mind you…that somethin’s gonna give. It seems unnatural for stocks to fall day after day – without something giving way. The Dow closed yesterday just 174 points above its Sept. low. That Sept. drop was easy to explain – Manhattan had just been attacked by terrorists. But now, what’s wrong?
Whether they wear suits or turbans, it’s getting harder and harder to blame recent market action on a few rotten apples. Good companies and bad – they’re all going down. And the dollar too.
Readers will recall a popular book in the late ’90s predicted that the Dow would rise to 36,000. The forecast was based on the idea that the "equity risk premium" – the extra earnings investors demanded from stocks, over bonds – was unnecessary. Over the long run, the authors argued, stocks were no more risky than bonds; there was no reason to expect more income from them.
Maybe, when the sun finally cools, we’ll find out that stocks really weren’t any riskier over the very long term. None of us will be around to know. In the meantime, we’ve got bills to pay; in fact, the average American has more bills to pay than ever. And he can’t send his creditors shares of Worldcom or Dr. Koop.com…and tell them that "they’ll come back." The S&P 500 is down 40% from its peak value. The "house money" is off the table; now the losses are real. The risk premium, we would bet, is going up…not down.
The market must be near the edge of panic…we guess… or an explosive rally.
Eric, que penses-tu?
Eric Fry, reporting from Manhattan:
– The monotonous Wall Street litany drones on: Dow lower, Nasdaq lower, S&P 500 lower…to a fresh 5-year low. The Dow dropped 133 points to 8,409, while the Nasdaq tumbled nearly 3% to 1,357. The S&P 500 fell 24 to 881.
– Understandably, bearish sentiment is on the rise. "More Individual Investors are Selling Short," The Wall Street Journal observed yesterday. "Fidelity Investments reports that short interest among its account holders is…up 20% since April." Investors are still swapping hot tips about tech stocks – but the hottest tips these days are about which tech stocks to sell short.
– A bearish view of the stock market has become so popular a position, that the "short side" of the market is becoming a very "crowded trade" – as the professional traders would say. In fact, the short side is getting more crowded than a New York subway car at 9 AM…But Mr. Market doesn’t care; he just hangs his head and keeps plodding downhill anyway.
– One after another, I have observed many longtime bulls convert to "the dark side." And once converted, they devote themselves to the fiendish task of recommending stocks to sell short. Suddenly, everyone is a "fundamental analyst" who thinks they have discovered the next Enron or Worldcom.
– From a contrarian standpoint – one would think that the market absolutely, positively must rally…just to frustrate the growing crowds of "newbie" short-sellers. But that’s not happening; the market keeps falling, no matter what anyone thinks.
– Don’t get me wrong; we at the Daily Reckoning are certainly nowhere near abandoning our cautious stance. My interest in a possible trading rally has little to do with stocks per se, but rather with the implications for the gold market.
– Will gold fade if the stock market rallies, or will it continue its steady climb higher? During phase one of the "Gold Bull Market of Twenty Aught Two," gold lurched ahead in response to every downtick in the stock market. But this inverse relationship has weakened recently. Gold has drifted down from its recent highs, even though the stock market has continued to slide.
– Is that all she wrote? Is the gold Bull market finished? Or rather, might Phase II of the gold Bull market of 2002 occur DESPITE a rally in stocks? Perhaps dollar weakness alone will power the next major gold rally.
– Certainly, the monetary bull case for gold has lost none of its allure as the dollar has tumbled more than 15% against the euro in just a few weeks…And Gold remains the time-honored alternative to depreciating currencies.
– "The central banks who have been sellers of gold were typically taking those proceeds and investing it in U.S. dollars," notes Richard Pomboy, a professional investor who is a fan of gold stocks. "But since the U.S. dollar has started depreciating, the question is are they going to pursue that avenue as vigorously as they did before? The answer is probably not. If they sell their gold, what are they going to buy?…Are the Chinese going to continue to buy dollars? Are the Japanese going to continue to buy dollars or will they start to build up their gold reserves, which are very small?"
– In the late 1990s, gold was losing badly to other, more popular, assets like the common stock of Cisco Systems. But the tide has turned. "Central bankers, regarding the barbarous relic as the monetary equivalent of a set of tonsils, were apparently prepared to let it go – all 30,000-plus metric tons they held," remarks Jim Grant. "Not even the Asian currency crisis in the fall of 1997 could revive the yellow dog. The monetary asset to which the world flew was the U.S. dollar."
– But no more. The dollar strength is becoming increasingly suspect, especially among those investors who do not hold a U.S. passport. – "J.S.G. Boggs is an artist who draws provocative versions of the U.S. currency, some so close to the real McCoy as to cause the Secret Service to take a lively interest in his work," writes Grant. "Boggs has given much thought to the pieces of paper that obsess him, and he asks some basic monetary questions. ‘It’s all an act of faith,’ says the artist of the institution of managed currencies (he is quoted in ‘Boggs: A Comedy of Values,’ by Lawrence Wechsler). ‘Nobody knows what a dollar is, what the word means, what holds the thing up, what it stands in for.’"
– The dollar’s ambiguous value and identity, however, did not impede its multi-year bull market. Folks just seemed to like greenbacks…for whatever reason, or for no reason at all. But if the obvious reasons for not liking the dollar – a gaping current account deficit, for example – start to gain a following, folks might learn to like greenbacks a little bit less.
– And if the dollar were to become less popular, gold might become a little more popular…It could happen.
Back in Paris…
*** Property prices in Paris have risen sharply in the last few years. In La Jolla, CA and Del Ray Beach, FL too. What gives? More below…
*** "Recovery looks more and more like a jobless one," says the USA Today. Between February and June, 131,000 jobs were lost.
*** Are investors really turning bearish? A DR reader from Trabuco Canyon, CA, writes:
"I have been reading ‘The Daily Reckoning’ for about 6 months and have found the content spot on. I have saved myself thousands of dollars by steering clear of this stock market thanks to your opinions. [Thank you…ed.] I had to laugh when reading the below comments from a Porsche message board. This is probably a fair representation of what everyone I speak with thinks of the current market. I hope you find it amusing.
Posted on Porsche Pete’s Boxster Board, July 16, 2002:
"Stocks continue to be the single best paper investment. Historically the stock market has always bounced back from every downturn.
"Money invested in the stock market in 1975 returned 13.2% per year AHEAD OF INFLATION by the end of 1998. Money invested in 1985 payed back 14.7% ahead of inflation over the same period. The recent downturn would only knock those returns down a little bit.
"Even if we go WAY back, stock market returns are impressive compared to other paper investments. From 1802-1870 the market returned 7% ahead of inflation. From 1871-1925 it payed 6.6% ahead of inflation. From 1926 to 1997 the payoff was 7.2%. Again, these numbers are ahead of inflation.
"There is nothing at all to suggest that this will not continue. Essentially everyone is saying the market is still undervalued. Most economic indicators are great. No one can answer your question of where the market will go in 3 months or a year, but a diversified portfolio held long-term should do quite well. I would not at all be surprised to see a 15,000 or even 18,000 Dow 5 years from now.
"Every cloud has a silver lining. The corporate scandals we see in the press right now could be creating one of the best times to buy stocks we have seen in a long time. At least I hope so anyway."
*** Irrelevant Family News: my two oldest children arrived from the U.S. yesterday for a vacation. Elizabeth and the little boys are still out on an island off the coast of France. But we all get together on the weekend.
The boys are all fairly calm at these family holidays. But the two girls can get wound up from the excitement of seeing each other after a long separation. Last night, walking back from a restaurant between Maria and Sophia, your correspondent felt that he was carrying two live hand grenades, one in each hand…and each with loose pins. Finally, when we got back to the apartment, Maria exploded.
"I just feel fat, ugly and incompetent…" cried the 16- year-old cover girl. Her older sister reassured her…then, her father comforted her, and the day ended.
*** Miscellaneous Housekeeping Details: The Oxford Club’s Steven King (no, not the horror writer) writes to say: "We already have people coming from Brazil, Switzerland and Canada…and we just started getting the word out." He’s referring to this year’s investment event in New Orleans.
It’s no wonder really…with the investment environment looking grim, investors are beginning to focus ever more on alternatives to Wall Street.