How Long Before the Bust?

If you’re worried about a housing bubble in your area, think about how the Brits must feel. The UK housing market has skyrocketed more than 50% since the FTSE began to fall. Yet, says Brian Durrant, of The Fleet Street Letter’s UK edition, there’s reason to believe the property boom could reach even greater heights before it busts…

If you’re a homeowner, you will have noticed that the property market is front and center in the headlines again. The Halifax, the UK’s largest mortgage lender, has reported a massive 4.3% rise in the price of the average home in September alone, and the average property in London now costs over £200,000. The Halifax has raised its estimate for price rises this year to 24%, up from an original forecast at the beginning of the year of just 5- 6%.

Virtually everyone agrees that house price gains at the current rate will be unsustainable in the next year. The key question is, are we in the throes of a speculative "bubble" that is about to burst? Or is this a housing bull market, where current valuations cannot be justified, but there is still more scope for further price gains, albeit at a slower rate?

The "property boom is almost over" camp has been wrong over the last few years. Over the past three years, the value of the average property in the UK has increased by 50%, easily outstripping growth in household earnings. Surely this cannot last much longer.

Pessimists of the property market tend to focus on what is going on in London. Here, the ratio of house prices to household earnings has nudged above 6 and is closing in on the peak of over 6.5 seen during the last bust in 1989. These pessimists point to job losses and falling bonuses in the City, while the dramatic drop in rental yields makes buying-to-let much less attractive than it once was.

The buy-to-let buyer was an important player in sustaining the boom in London house prices, at a time when prices were moving out of reach for first-time buyers. Just as fresh buyers are drying up, there has been an increase in Londoners trying to sell their property. But the sellers are not having much luck, particularly at the top end. Properties over £500,000 are proving difficult to sell because of the onerous 4% stamp duty.

This is undoubtedly the experience of some individuals, but the pessimists’ case is largely anecdotal. The reality is that against the evidence portrayed above, property prices in London rose by over 7% in the last three months, and by 19% over the last year.

Still, bust levels for the housing market are some way off. For that reason we remain optimists about the housing market and prefer to look at the wider picture. The key to understanding the prospects for the housing market is affordability.

For the country as a whole, the level of house prices relative to annual household earnings is about 4.25, compared to the 5 level recorded at the peak in the last housing boom in 1989. So house prices have scope to increase by at least 15-20% before this crucial ratio reaches 1989 "bust" levels.

Moreover, even after an increase of this scale, houses will not be as unaffordable as they were in 1989 because interest rates are much lower. Mortgage interest payments currently take up 15% of a household’s earnings. Back in 1989, that proportion was 35%. Indeed, the background of low high street inflation, stock market weakness and worries about the global economic recovery should keep interest rates low in the near future.

Probably as important as low interest rate prospects is the outlook for employment. Despite the bust, September 11 and the bloodbath in equity markets, unemployment continues to fall in the UK. The reality is that well-publicized job losses in the City and high-tech industries are more than offset by heavy recruitment in construction, the public sector and retailing.

And although trading conditions for companies may be tough, managements are finding it cheaper to hang on to staff in a downturn than face recruitment and training costs when the economy starts its recovery. So, as long as the economy continues to inch forward, unemployment should remain low and stable, providing a platform for continued house price growth.

The property market in the UK follows a familiar cycle. Price action in London is the leader. This region is the first to catch on to a rise in prices and the first to cool off. The rest of the country is influenced by a ripple effect emanating from the capital.

When a boom in London gets underway, the South East tends to follow suit fairly quickly, followed by East Anglia and the South West. The Midlands is the next region to play catch up, and so on. Looking back to the experience of the 1980s, the annual rate of increase of London house prices reached its peak some two years before the housing market as a whole started falling. Property price gains in London are not yet even decelerating.

On the basis of past patterns we expect to see property price rises continuing into next year, with regions outside London and the South East showing the biggest gains. Furthermore, the structure of taxation and employment trends points to greater price potential in lower value properties. Clearly house prices cannot go on rising by 20% a year and we see gains moderating to single figures next year.

We do not see a hard landing for the property market in the next 12 months…but if conditions change, we will be the first to tell you.


Brian Durrant,
for The Daily Reckoning
October 22, 2002

Editor’s note: Brian Durrant is a Cambridge economics graduate with nearly 20 years of experience in and around the London Stock Exchange. He’s worked as a stockbroker, a financial journalist, and has headed the research department of London’s leading futures and options broker – which makes him ideally placed to ensure that UK readers of The Fleet Street Letter profit from his exclusive network of contacts.

While the average 401(k) holder grimaces at the sound of the mailman delivering his monthly punishment, there remains a single source of solace. The latest subject of cocktail parties, and the next extraordinary popular delusion of the US investor: the single-family home…and the "cash-out" refi.

"Everyone knows the drill," writes the Prudent Bear’s David Tice in the current issue of Strategic Investment. "You pay your mortgage until rates drop, then refinance. You borrow more than enough to pay off your loan balance, but thanks to lower rates, your monthly payments remain the same. As a result – you walk out with a check for $20,000 or $30,000."

And thus is the US consumer fattened a little more…the economy given another month’s reprieve…and the ‘imperial currency’ allowed a few more delicious breaths on the world’s center stage.

According to Tice, the "refi" boom of 2002 will "beat last year’s hands down." No easy task, considering Americans extracted $138 billion from their homes last year. "Annualized consumer spending for the June quarter came in about $300 billion higher than the year [before]"…making "cash-out" refinancing responsible for about half of the increase in the consumer spending component of GDP over an entire year.

Population growth, the peace dividend, immigration, the "strong economy" of the 1990s, the lowest mortgage rates in nearly 40 years…name your poison. Not only have house prices been driven firmly higher, but the phenomenon has convinced the average tract house owner – while he may have to admit he’s not the stock market wizard he once thought he was – there’s a good chance he’s darn good at the property game.

Why not take advantage of the low rates and "cash-out" a little…buy a new car (at 0% financing and no down payments for 90 days, no less!)…pay off some credit card debt… and wait around a little until the stock market begins to boom again? Sounds so easy…why wouldn’t you do it?

Apparently, it’s a no-brainer.

In 1982, Gary Shilling tells us, the average homeowner’s equity stake in his own home was about 30%. Today…at the other end of the great bull…that number has plunged to 16%.

Unfortunately, that lays the debt-addled, stock-swatted American balance sheet squarely on a shaky foundation. "Buyers who put 20% down on a home purchase that falls 10% in value would see half their equity wiped out," notes a report on CBS MarketWatch.

So far, so good. The second quarter showed only one of 185 markets nationwide in decline: San Jose. In fact, the House Pricing Index indicates the average price of a US home increased 6.5 in the second quarter…pfheww!

Still, that increase number is slower than the 9.2 high recorded in the first quarter 2001. And September saw the number of foreclosures in the US hit its highest level in 30 years. What’s more, in response to plunging profits, according to a recent survey of 431 companies conducted by Watson Wyatt Worldwide…53% plan to reduce staff in 2002… another 46% plan to reduce salaries or have enacted hiring freezes…and another 21% plan to severely cut bonuses, or eliminate them altogether.

With a weakening job market and slowing income growth, one can only wonder how much longer Johnny Q. can hold out. What would happen, for example, if credit began to tighten ever so slightly…or if Fannie Mae, like a drug pusher who’s already given the first dose for free, announced a fee increase on "cash-out" refinance mortgages effective in February of next year?

Wait, they already did.


Eric, what happened on Wall Street yesterday?


Eric Fry in New York…

– "A growing appetite for risk" inspired yesterday’s stock-buying binge (and gold-selling purge), according to a Dow Jones newswire story. Yessiree! Investors are hungering for a heaping plateful of risk. We’ve got a feeling that Mr. Market, like a doting grandmother, will see to it that investors get their fill.

– Investors gorged themselves yesterday on a potpourri of high-risk equities. The Dow gained 215 points to 8,538, while the Nasdaq added 22 to 1,309. Amidst the feeding frenzy, many investors gobbled up rich little morsels like Lucent Technologies and Nortel Networks.

– Lucent and Nortel "soared" 7.4% and 23.8%, respectively. These gains seem pretty impressive, until one realizes that Lucent shares added one meager nickel to close at 73 cents and that Nortel jumped a whopping 15 cents to 78 cents…Not a bad day for the "penny stocks" on the NYSE.

– Although we at the Daily Reckoning like to think we have a very cultivated palate, we have never managed to acquire a taste for risk. Sure, we might nibble on it a bit, just to be polite. But otherwise, we try to avoid the stuff. A little bit of risk – like a little bit of foie gras – goes a long way. No one should sit down to an entire meal of it.

– While stocks continued their dramatic rally yesterday, gold and bonds both stumbled. The precious metal dropped $1.80 to close at $311.50 an ounce. Meanwhile, government bonds resumed their harrowing nose-dive. The 10-year Treasury note fell more than one point to push its yield up to 4.23% from Friday’s 4.10%…Deflation may yet swallow the American economy whole. But, for the moment, bond investors seem not to care about either deflation or inflation. They care only about getting out as fast as they can.

– Remember IBM’s "strong" earnings report last Wednesday – the one that sparked a 238-point Dow rally? Didn’t it seem strange that IBM managed to turn in a decent showing when almost every other tech company on the face of the planet is "sucking wind?" Well, as it turns out, IBM’s earnings weren’t that strong after all, according to Paul Kasriel and his team at Northern Trust.

– Here’s the skinny: IBM management boasted that its per- share earnings increased year-over-year…That’s ONE way to look at it. But there’s more to the story. IBM’s earnings from continuing operations in the third quarter were down 1% from one year ago. Worse, Big Blue’s actual net income fell 18%, but this decline includes earnings – or lack thereof – from discontinued operations. Despite the earnings falloff however, earnings per share increased 2 cents in the third quarter versus one year ago. How could this be?

– "Well, you don’t have to figure too long to find out what is going on here," says Kasriel. "Obviously, the number of IBM shares outstanding fell versus one year ago." In other words, it’s the same old share-re-purchase game that IBM has been playing for years. Earnings aren’t actually growing, they just appear to be growing when measured in terms of earnings per share. That’s because IBM spends so much money buying back its stock that the number of shares outstanding steadily decreases. This process has the effect of making earnings per share increase, even when the actual earnings do not grow at all.

– "This, of course, is what corporations did during the ‘Roaring Nineties’ to boost their EPS," Kasriel continues. "And now they are paying for it in plummeting bond ratings. Wall Street went gaga over IBM’s third- quarter report. What am I missing here?" Nothing, Paul…Nothing.

– Wall Street also "went gaga" last week over Microsoft’s earnings. But CEO Steve Ballmer said over the weekend that the company’s latest results were "kind of a one- time anomaly…We’re still seeing business as being reasonably tough, at least compared to, let’s say, the good old days."

– The story is monotonously similar throughout Techland. "I don’t see any point, given the uncertainty that we have in the economy and the PC industry…that there’s any point to being optimistic right now," said Fred Anderson, chief financial officer of Apple Computer Inc., which posted a quarterly loss last Wednesday. "We’re planning for the worst and hopeful that things will be better."

– The outlook is equally bleak outside the tech sector. "Looking ahead, there are no clear signs of improving global economic conditions," 3M Chief Executive James McNerney, Jr. said yesterday.

– In short, even the "good" earnings reports aren’t that good. But that hasn’t prevented investors from adding more than 1,200 points to the Dow in less than two weeks. Investors have, indeed, "regained their insanity."


Back in Paris…

*** "Deflation denial continues to pervade the macro debate," writes Morgan Stanley’s Stephen Roach this week. "I usually introduce the topic into my presentations by asking the assembled clients to indulge me in the American children’s game of ‘word association.’ I will say one word, and they have to come up with the next word that immediately pops into their minds. The word I select is ‘deflation,’ and the unanimous response is ‘Japan.’

"To the extent that America can distinguish itself from the Japanese experience – solvent banks, flexible markets, mark-to-market securities pricing, a two-party political system, etc. – the case for US deflation is then usually dismissed out of hand. That’s when I pause and add that you don’t have to be Japanese to worry about deflation."

*** As you know, we here at the Daily Reckoning are keenly interested in the long, slow-motion deflation suffered by Japanese consumers over the past decade…so much so that it has become the subject of the book we’re writing. But today, given the state of the great ‘refi’ boom of 2002, the analogy provided for us by the Japanese example seems to have taken on a more ominous note.

Again, Mr. Roach: "I hear repeatedly [the excuse] that Japan’s bubble was much bigger than America’s. After all, it wasn’t just the Nikkei; it was also an outsize property bubble. It was the interplay between these two asset bubbles that wreaked such havoc on Japan in the late 1980s and early 1990s.

"The truly astonishing thing is that America can’t look in the mirror and see precisely the same pattern. The Nikkei reached its peak of 38,915 on December 29, 1989. Over the ensuing 21 months it would go on to lose 38.5% of its value while Japanese land prices, as measured by the Japanese Real Estate Institute, would continue to rise by approximately 15% before peaking in September 1991.

"Fast forward to America. Between December 31, 1999 and September 30, 2002, the S&P 500 lost 45% of its value – actually worse than the initial decline in Japan. Over the same 33-month period, nationwide US home prices as measured by the Fannie Mae (OFHEO) index rose around 15%. If that’s not Japanese-like, I don’t what is. Property bubbles typically outlast those in the stock market. It was true of Japan in the early 1990s, and it appears to be true of America today."

Of course, we’ll keep you posted…as the Great Deflation continues…

Addison Wiggin,
The Daily Reckoning

The Daily Reckoning