Imminent Crash?

Argh! I should have bought back then!

About six years ago, I lived in Delray Beach, Florida. My wife and I had considered buying a place on the beachside, within walking distance from the beach. At the time, large two-bedroom townhouses were going for between $130k and $170k. We even made a few lowball offers, which weren’t accepted. I ended up moving to Baltimore. But friends of ours did end up buying places we looked at, and my parents also bought as an investment.

Wow. They sure look smart now.

I returned to Delray earlier this month (to host our annual Investment U seminar), and I couldn’t believe what had happened. Friends who I know paid around $135,000 (because we looked at the same unit they bought) are putting that place up on the market for $450,000. The unit next to my parents just sold for about triple the amount my parents paid. Good for them – they were in the right place at the right time. (And we did well in Baltimore also; there’s a real estate boom going on there, too.)

A boom in the town known as “Dull-ray” Beach? A boom in Baltimore? I know you’re probably wondering, “Steve, how can you say there’s no real estate crash imminent?”

There are two things to point to: value and buyers.

Real Estate Bubble: More Affordable than Ever

In the last year or so, homes have been more affordable than they’ve been in over 25 years. Today, a household that makes $50,000 a year can easily afford a $150,000 house. At 5.5% interest, a 30-year mortgage would cost less than $900 a month – or about 20% of monthly income.

That’s extraordinary. Take that same family in 1981. To buy the median house back then (which was only $130k when you adjust for inflation), it would have cost $1,630 a month in today’s dollars – nearly twice as much as right now… and about 40% of income. This is because mortgage rates in 1981 were 15%.

Low mortgage rates have changed the buying dynamic. Families that used to rent are now buying. Low mortgage rates have caused a dramatic increase in the buying pool.

As for value, it may be hard for most to believe, but even if we ignore mortgage rates, the fact is that housing prices in the U.S. are still at about 1989 levels when you adjust for inflation. Since 1989, stocks have tripled (the Dow is up from 2,500 to 7,500 today, after nearly reaching 12,000 in January of 2000). Meanwhile, home prices in that time are flat.

Another way to look at value is by looking at EARNINGS. Just as we look at the price-to-earnings ratio of a stock, you can look at the price-to-rental earnings ratio of a house. Stocks would have to fall by about 50% to return to being “in line” with the average price-to-earnings ratio. Meanwhile, a study this month by the Federal Reserve Bank of San Francisco shows that housing prices would have to fall by 11% to bring the ratio back to its long-term average. This may be a little worrisome, but it’s not the end of the world. The author of the study expects that home prices may not even fall; rather, rents will simply catch up by 2005, bringing us back to fair value.

Real Estate Bubble: Home Prices in Ireland

According to a recent Economist magazine, home prices in Ireland have risen 203% since 1995. In Britain and the Netherlands, they’re also up triple digits. The U.S.’s 5.7% annual gain over that period seems downright paltry.

Similarly, in Australia and Spain, home prices rose by about 18% in 2002. Meanwhile, in the fourth quarter of 2002, U.S. home prices only rose at an annual rate of 3.3%.

For the many years that I have been writing about investing, I have never predicted a crash in U.S. real estate. Yes, there are some “bubble” areas in the U.S., and you know them if you live near them. But on the whole, I don’t think real estate is wildly overvalued. The gentleman from the San Francisco Fed may be close, suggesting that home prices are a little overvalued. But that definitely does not mean that the bull market in real estate can’t continue. Stocks were overvalued for many years and kept rising until the crash came in 2000.

The facts, as reported by the Housing Affordability Index, suggest that in the last year, homes have become more affordable than they’ve been in over 25 years – primarily due to lower mortgage rates. At the moment at least, there is demand from new buyers, and supply is tight. Prices could move higher.

I don’t have all the answers, of course. However, there is one more point I’d like to make. “Real estate is expensive” – there’s unanimous agreement on this fact at cocktail parties. Of course, in late 1999, there was unanimous agreement at cocktail parties that the way to instant riches was through tech stocks.

Whenever the cocktail party crowd reaches a unanimous conclusion about an investment, it may pay to consider the opposite possibility.


Steve Sjuggerud
for The Daily Reckoning
March 31, 2003


Several headlines over the weekend mention “recession”. The prospect of 360,000 U.S. troops putting down roots in Iraqi sand troubles the economy. Or at least, it troubles economists. The economy was already troubled long before George W. Bush decided to bring freedom to the desert.

The “shock and awe” campaign seems to have impressed no one – neither the Iraqis, nor investors, nor economists. Stocks are lower than they were a week ago. Gold is higher, by about $6. And gold stocks? They rose about 6% last week.

The entire world economy is “dysfunctional”, says Stephen Roach. The U.S. has been the world’s growth engine for many, many years. But now, American consumers can’t seem to get their motors started.

Consumers continued to buy in February. But for the second month in a row, there was no growth in consumer spending – despite record amounts of new money entering the economy through mortgage refinancings.

Where’s the money going? Well, it appears to be just enough to allow householders to stay in the same place. Mortgage interest alone is running at about $265 billion annually. Property taxes, up nearly 50% since 1995, add a couple hundred billion more.

After servicing his debt and taxes, the consumer just doesn’t have enough fuel left over for his growth engine. “War…and the peace that eventually follows…changes none of this,” says Roach.

We’re not so sure. We old fuddy duddies here at the Old School Daily Reckoning remember when a billion dollars was real money. Now, people toss a few billion here, a few there, as if it were chump change. Operation Iraqi Freedom, alone, will probably end up costing about $200 – $300 billion…or about $2,500 per household. Since millions of families are already at the edge of insolvency…the extra costs of the war will probably push thousands of them into bankruptcy. On the homeland front as well as the Iraqi one, there may be more casualties than expected.



Eric Fry in New York…

– The stock market slowed its advance toward Dow 9,000 last week, as it struggled to consolidate and fortify its position around the 8,000-level. The pause may have been necessary to enable the re-supply of buy orders to arrive at the front lines. Complicating the efforts of the investor-infantry, sandstorms of economic uncertainty swirled through the ranks.

– By the end of last week’s skirmishes at Wall and Broad, the Dow had retreated 376 points to 8,145 and the Nasdaq had pulled back 3.7% to 1,369. The dollar also beat a retreat, falling back to $1.078 per euro from $1.052 the week before.

– Meanwhile, the safe-haven asset classes charged ahead into the macro-economic fray. T-bonds, oil and gold all gained ground last week. Crude oil led the commodity brigade by advancing more than 10% and reclaiming the $30- level.

– Most oil and gas stocks gained ground last week, even as all the major equity indices fell. The XNG Index of natural gas stocks and the XOI Index of oil stocks both closed out the week at their highest levels since the war started. The surprising thing is not that energy stocks rallied last week, but that they didn’t rally more. The oil price jumped more than 10% to finish the week above $30 a barrel. Even so, the XOI Index gained less than 1%.

– Complacent bearishness toward oil and gas was one of the earliest casualties of the Iraqi conflict. Prices are soaring throughout the energy complex. Yet the shares of most energy companies continue to lag behind. “There are a lot of cheap oil and gas stocks out there in the stock market right now,” says Robert Tracy of Apogee Research. Your co-editor is inclined to agree, which is why he refers to oil and gas stocks as “chicken longs”.

– Many oil and gas stocks remain quite inexpensive, despite the big rallies in their respective commodities. That’s because – prior to the war – most investors anticipated a swift and decisive victory over Iraq that would bring an equally swift and decisive end to soaring energy prices. Since investors KNEW that oil prices would fall as soon as the first Tomahawk cruise missile fell in Baghdad, they also knew that they shouldn’t buy oil and gas stocks. However, the first tomahawk has now landed, along with a few hundred more, and the Iraqi regime still stands. So oil is flying to the upside once again.

– Apart from the low valuations that typify most oil and gas stocks, the sector seems to be sitting in a win-win position. A swift U.S. victory in Iraq would likely boost the stock market, permitting oil stocks to trade higher in sympathy with the general market trend. Alternatively, a lengthy campaign in Iraq would likely boost the oil price, thereby boosting the profitability of oil and gas stocks.

– Then too, there’s the whole issue of resurgent inflation, the possibility of which Alan Greenspan and most other experts have ruled out. Weighing in against these expert opinions is a $100 billion – and growing – tab for the Iraqi conflict, a $300 billion – and growing – federal deficit and a $500 billion – and growing – current account deficit. A little bit of inflation would make those debts a lot more manageable. And even a little bit of inflation would do a lot of good for oil and gas stocks. That’s because the oil price is most often one of the items whose price inflates during an inflation, thereby inflating the profits of oil and gas companies.

– An investor could do worse, we imagine, than to sell long-dated U.S. Treasury bonds and buy high-yielding oil and gas stocks. One institutional bond salesman recently mentioned to Jim Grant, editor of Grant’s Interest Rate Observer, that he was selling an 8-year Treasury note yielding 3.41% to buy the common stock of British Petroleum (BP), yielding 4.55%. BP has rallied a smidge since then, but still yields 4.07%. By comparison, the 10-year Treasury note closed out the week yielding 3.90%…Pick your poison!


Back in Paris…

*** From Tim Freeborn in our London office:

I’ve been checking my history books and have found uncanny parallels between the Iraqi war and the Boer war:

1) An Imperial power, apparently at its zenith, but in fact in serious relative economic decline.
2) Huge international opposition.
3) Struggle for control of key resources: gold, oil.
4) Fairly early conventional victory followed by massively expensive guerrilla campaign lasting two years.

The London market rocketed when war was declared in 1899. Then, interest rates went up as government borrowing soared. Equities fell on early defeats…and then generally suffered with the economy. In the end, Britain did win, but its economic performance in the following decade was poor.

*** “I don’t like the way this war is going,” said Col. Aubray, after Sunday’s mass. Rare among the French, the old soldier seems sympathetic to Bush’s war. But it brings back bad memories.

“It reminds me of the Algerian War. You know, we had a huge military advantage. And we actually won the war, militarily. I remember I was stationed at a tiny village…I was the only European for miles around. And they encouraged us to bring our wives…to show that it was all very safe and ordinary. So Marie-Noëlle came with me. We had friends in the village. But we were never sure when they might try to cut our throats.

“And Algeria was not like Iraq. The French had been there for hundreds of years…it was a department of France, like a state in the U.S.. But once the locals decided to get rid of us, we couldn’t stop them.

“And we paid a terrible price. I don’t mean just money, either. That kind of guerilla warfare – house to house, where you can’t trust the civilians and never know who’s going to try to blow you up – degrades an army. Terrible things were done during the Algerian war…on both sides. And in the end, we had to leave. It was just too costly to stay.”