Houses Without Moats
It is over.
The Golden Age of Central Banking – when giants such as Alan Greenspan, Robert Rubin and Larry Summers walked the earth – has come to an end. Now, day by day, Mr. Greenspan shrinks. Before the trend is over, he will be a midget.
We hear the hissing sounds already…other economists carping about his ‘errors’…investors whining about their losses…politicians eager to stick him with the blame.
There is also the hissing from his many bubbles. Stocks leak air almost every day. Bankruptcies reach record levels. Junk bonds get trashed and debts go bad in record numbers. And consumers’ knees grow weak and weary from toting so much debt.
Consumers will be the last to catch on. As recently as a month ago, they thought they could borrow money without worrying about paying it back. Jobs would be no problem. The cash would keep flowing. Stocks may crash, they believed…but the housing sector is still growing and solid.
But yesterday brought news that the housing bubble may have found its pin. Housing starts fell 2.2%. Lumber cracked – dropping below the $10 limit.
Mortgage delinquencies at a record 5.7%…and foreclosures at the highest rates since they began keeping records…have begun to hammer away at both the builders and the lenders. Kaufman and Broad fell $3.26. Lennar dropped nearly the same amount.
And Fannie Mae – the greatest of the housing bubble stocks – slipped to $67.
Anecdotal evidence is beginning to show up too…and seems to be gathering a crowd. The smart money is selling, not buying:
"I bought this piece of land [near Middleburg, VA] about six years ago. I marked it up to 4 times what I paid for it and sold it before I even had it listed," reported a friend over dinner last night.
But in other areas, people say it is taking longer to sell houses. Rental rates are said to be falling off. Vacancy rates are increasing.
As reported here earlier, housing prices have risen 30% more than the inflation rate over the last 7 years. Why should house prices increase faster than everything else? We have a partial answer: because you cannot import a house. Consumer price inflation has been coming down for 2 decades. But housing has bucked the trend in most areas. The Chinese are making more and more TV sets. They are making so many of them, so cheaply, that prices have been falling for many years. But the Chinese do not build houses for Americans… Even in America, though, people can still make things – if there’s money in it.
Years ago, your editor recalls that his cousin prepared to go into the construction business:
"What do you know about building houses?" was the question put to him.
"Nothing…what do you need to know?" answered the cousin.
"Don’t you need a lot of tools and equipment?"
"I’ve got a hammer and a saw…what more do you need?"
And so the cousin went into the home construction business in 1972 and did well at it.
The typical American house is hardly a work of beauty or consummate engineering. In a matter of days, it can be hammered together out of pre-fabricated parts by a crew of illiterates. Over the long run, and making no allowances for local conditions, there is no reason for houses to be any different from other consumer items. They can beat the general rate of inflation for a while, but not for long.
Warren Buffett points out that the only way you can be fairly sure of protecting a profit margin is to own a business with a moat around it – a high cost of entry that makes it difficult for others to compete.
Some places have natural moats – mountain villages, such as Aspen, Colorado, with little available land…or islands, such as Manhattan…or seaside resorts, such as Naples, FL, whose backs are to the ocean. Not surprisingly, these are the places where property prices have risen most quickly. In San Diego, for example, with its huge moat on the west side of town…stretching all the way to China…housing prices have been going up at 20% annually.
But there is no moat around St. Louis. Nor is there one around Baltimore or most other cities. As long as property prices rise faster than the cost of capital, builders will continue putting up marginal houses in marginal areas and selling them to marginal buyers with marginal financing.
That is the thing about a bubble that is almost indescribably wonderful. Things that people might have considered foolish and stupid begin to look reasonable. The housing development, for example, that was a loser at 10% mortgage rates, becomes a winner at 6%. People who could barely afford a double-wide find themselves with a mini-mansion with plastic siding and a maxi mortgage. And gradually the supply of houses catches up to even the most marginal demand.
And then a change begins. "For Sale" signs stay up longer. Foreclosures rise. Builders and lenders begin to lay people off. And suddenly, it begins to look as though the last of Greenspan’s bubbles has popped.
September 20, 2002
Along come two of Wall Street’s celebrated strategists with this updated forecast:
"Our year-end S&P 500 price target is unchanged at 1075, as is our Dow Jones Industrials target of 10,250," say Jeffrey Applegate and Charles Reinhard. Their guess might be as good as anyone else’s. But then the two add: "We think that the central bank is alert to the downside risks, and we may still need [an easing of interest rates by the Fed] to get us to those price targets."
Do these guys just make this stuff up as they go along? Had they not heard Greenspan’s Jackson Hole speech? Have they never heard of Japan? Or read about the Great Depression? Have they been unconscious since the Fed began cutting rates in January of 2001?
Greenspan said he couldn’t tell when stocks were getting too high…and what did it matter anyway; he couldn’t do anything about it. Then, when Mr. Market took the initiative and did something about it himself, the chairman quickly knocked 475 basis points off the Fed Funds rate.
Whether he could have stopped the bubble or not, we don’t know. But we know he couldn’t stop it from collapsing once it sprung a leak. But that’s what happens when bubbles pop; dropping rates doesn’t help. It just makes the situation worse, encouraging people to dig deeper debt holes for themselves…from which they will eventually have to climb out.
What a wonderful world it must be for Applegate and Reinhard! Every day…and every event…must come as a complete surprise.
"Wow…check that out…" one says to the other. "What is it?"
"It’s called the sun," says the other, after checking with a colleague. "They say it comes up every day at this time…unless it’s cloudy…"
Who knows. The two economists might get lucky. They were very lucky throughout the bull market. But when the tide turned, they were washed out with all the other pieces of dead wood on Wall Street. And there are few signs that the bear market trend will stop any time soon.
"This is the Big Daddy of bear markets," wrote Richard Russell yesterday… "one hell-bent SOB that is intent on doing untold amounts of damage."
Gold rose 2.10 yesterday. The dollar fell. And treasury bonds went up while the gap between inflation-indexed TIPS and regular 10-year notes narrowed to 1.58. Bond investors are predicting a deteriorating economy.
All that has been sustaining GDP growth in the US has been auto sales, housing, and the lingering belief that somehow Alan Greenspan has things under control. But since Jackson Hole, even economists are beginning to mark down the Fed chairman’s stock…and now comes news that auto sales may have peaked.
"Car, truck buyers slam on the brakes," says a MSNBC story. Sales were off in the first 2 weeks of September. Of course, a single swallow is not a summer…and 14 days do not a trend make. But auto buying is bound to come to a red light sooner or later.
So is housing…about which, more below.
Eric is on a plane this morning. Addison brings us the latest news from Wall Street:
Addison Wiggin, from just across the desk…
– I remind you this morning of the words of the immortal Harry Schultz: "However much your intellect might believe that economic and technical factors point to a protracted bear market, your heart will inject the hope that the data is wrong."
– The hardest part, suggests Harry, of making money during a bear market is facing up to the fact that we are in one. But "in one", we sure seem to be. As if to punctuate the point with authority, the Dow dropped 230 points yesterday, landing with a thud at 7,942…the index’s first visit below 8,000 since July.
– Less than a month ago, the Dow appeared for all intents and purposes to be on the mend. August 22nd even saw the index poke its weary head above the 9,000 level – if only for the day. Alas, it was just one more in a long line of seasonal rallies and another chance for the bear to partake of a few more heapin’ helpins’ of investor capital. August 22nd was the peak of the rally. Since then the Dow has lost over 1,000 points…and investors have lost another trillion bucks, or so.
– "You want to feel better about your portfolio?" John Mauldin asked me hypothetically over the phone yesterday. "Look at what the pros are doing. They’re getting their heads handed to them on a platter." Mauldin, who keeps an eye on hedge funds for his Accredited Investor Letter, said yesterday that of the hundreds of hedge funds employing the "Classic Jones" strategy – a healthy mix of ‘longs’ and covering ‘shorts’ – the top 31 all lost money in July.
– It’s no wonder really. July was a brutal month, too… early in the month, on July 5th, the Dow was happily flirting with 9,400, but just 18 days later it had plunged to the year’s lowest point of 7,702. Now, only September appears to be poised to outpace the mid-summer decline and regain the year’s low. Over the last three trading sessions the Dow has shed 438 points. It makes your editors at The Daily Reckoning want to pose the question once again: Can all-out "panique" be far away?
– Certainly not…that is, if you’ve got a masochistic streak and like to spend your time reading the mainstream press. While perusing the market news this morning, I happened across a series of articles from Fortune Magazine dated September 30, 2002. "September 30?" I thought, "Excellent…if these guys can see into the future ten days then maybe THEY have something I can pass on to Daily Reckoning readers that actually HAS value."
– Unfortunately…it’s not be. In ten days time, I’m sorry to report, you’ll be treated to the same nonsensical, misguided and thoughtless analysis you’ve come to enjoy over the past four or five years of financial reporting. But what do you expect, really? With headlines like these: "The Never Ending Spending Spree," "Don’t Forget The Silver Lining" and "Why We’re Not Turning Japanese", the editors at Fortune have already set a high hurdle for themselves. (Don’t worry, I’ve done the legwork. I’ve read the articles so you can spend your time doing something more pleasurable – like clipping the nose hairs you’ve been neglecting, or perhaps, cleaning out the mysterious pile of refuse growing in the back of your garage.)
– In a nutshell, here’s their argument: While it’s true that "every attempt at a stock market rally in the U.S. sputters, and every decent economic indicator that comes out is invariably followed by a lousy one," and while interests are already at 30-year lows and we’ve already seen early signs of deflation, we are not, I repeat NOT, experiencing the same kind of post-bubble hangover as Japan.
– Why? It’s simple. Capitalism. The Japanese never really had it…and just look at the "creative destruction" eating up US telecom companies. This is American capitalism at its finest: telecom companies – old boys (Corning) and new kids on the block (Worldcom) alike couldn’t pay their bills…so out they go. Japan is stagnant and their "crony capitalist" banks are like zombies in The Night of The Living Dead. (I’m not making this up…that’s the real analogy used by the Fortune writers.) But not in America…once we "tighten up accounting standards, whip lax corporate boards into shape, and put [our own] crony capitalists in jail" investor confidence will be restored. And the US can resume its ever-skyward ascension.
– It doesn’t stop there. "Ever since the stock market began its swan dive in the spring of 2000, economists and market watchers have been posing the same question: "When is consumer spending going to give out?" another article dated September 30 begins…then boldly continues: "We’ve got a shocker for you: it’s not."
– Why? Well, as they say, most people still have jobs, and whatever "negative wealth effect" investors have suffered from stock market losses has been ameliorated by – you guessed it – rise in the value of their homes! "This has allowed consumers to tap billions of dollars’ worth of equity in their homes…and free up cash for spending on other goods." As positive proof of the trend, the article cites a Mortgage Bankers Association reports indicating refinancings in the first week of September were up 19% – to their highest level in history. [oy…] "Helping to fuel the spending spree," the articles bumbles on, "is that most American of traditions: easy credit. While businesses have had a hard time borrowing, consumer credit continues to expand – it rose to $10.8 billion in July, an 8% annual increase." This, remember, is a good thing.
– To recap…the US is not going the way of the Samurai, because a) we’re going to put our crony capitalists in jail and b) because Americans, historically and by tradition, have no fear of spending money they don’t have. Hmmmnnn…our system seems so vastly superior I can almost feel the rebound beginning as I write. And let’s not forget the "silver lining" in all this…"one new-economy shibboleth has survived the bust: There really is an productivity boom." [Oy, again. Are these guys for real? Even Easy Al the-mortgage-lender’s-pal seems to have given up on that one.]
– Well, at least we’ve had a chance to look into the future this morning and see: "Plus ca change, plus c’est la meme chose." – the more things change…the more they stay the same. Unfortunately, for the time being, staying the same means we’re likely not only to see a vicious bear marauding through the Great American Portfolio, but the financial media boldly leading investors back into the fray at every opportune moment.
Still in Paris…
*** "The Trade of the Decade," your editor guessed at the beginning of 2000, would be to sell the Dow and buy gold. I hope I did not forget to tell you, dear reader. "It’s so cheap and it acts so beautifully," says Michael O’Higgins of gold. The Dow usually sells for about 10 times the price of gold, he points out. At the beginning of 2000, it took 40 ounces of gold to buy the Dow. Now, it’s down to 26. To get back in balance, either stocks get cut in half or the price of the metal doubles.
Since the beginning of 2000, the price of gold has risen nearly $40 – or about 15%. The Dow, meanwhile, is down from 11,641 to under 8,000 – for a loss of 30%. Note: there are more than 7 years left in the decade. And nothing says the price of gold has to stop when it reaches one-tenth the Dow. In 1980, the two were about even.
*** "Grandma and I got back from Parma," Maria reported in from Milan by phone. "They had warned me that the photographer was a weirdo. And he was a weirdo, but not that weird. Besides this whole business is full of weirdos.
"But I’m starting to like Milan. The food is better than in Paris. It’s fresher…lighter. They use a lot of olive oil rather than butter.
"And the Italians are great. I just like the way they say ‘Ciao, Bella’ to me every morning…"
Next week, your editor will be writing to you from Milan. He is going to join his daughter and relieve his mother. Until then…Ciao…