Jeff Saut Presents: The Ownership Society
This real estate love affair was reflected once again in last week's eye-popping housing figures...
Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.
The "Ownership Society" is a phrase lionized by President Bush and the Republican Party. As stated by our President, "If you own something you have a vital stake in the future of our country. The more ownership there is in America, the more vitality there is in America, and the more people have a vital stake in the future of this country." Clearly, Americans have taken these words to heart and embraced the ownership of property, emboldened by low interest rates, fancy financing vehicles, and rising property values. This real estate love affair was reflected once again in last week's eye-popping housing figures (building permits +6.8%).
Many pundits argue that this real estate "wealth effect" will extend ad infinitum, giving the U.S. consumer the ability to continue to attempt to "spend themselves wealthy!" Yet, the sea of real-estate-induced consumer liquidity is to some degree illusionary now that housing prices are stagnating, or in some cases actually falling. Indeed, it is head-turning cocktail conversation to tell folks that the $400,000 house you bought five years ago is now worth $1 million. However, what is often left out of the conversation is the fact that your $1 million house has a $1 million mortgage and that the equity you extracted from that house has been used to buy an airplane, a boat, cars, vacations, etc. This becomes especially problematic in a rising interest rate environment since nearly $2 trillion of these variable interest rate loans are going to reset at much higher interest rates over the next few years.
Verily, Raymond James' real estate research team has been cautioning on real estate recently and has surfaced some rather alarming housing statistics over the past few months. From a macro perspective, such concerns appeared in a recent New York Times book review, written by Lisa Scherzer, about the book "Empire of Debt: The Rise of an Epic Financial Crisis" by authors Addison Wiggin and Bill Bonner. To reprise a few lines:
"Ostensibly, America is the most prosperous nation on the planet. But, it's also the world's largest debtor and biggest consumer. . . . Americans buy houses as investments, drain their homes of equity and spend what they don't have. Folks are living well above their means, yet drowning in an ever-rising sea of debt. Any number of financial crises will contribute to the U.S. economy's demise, according to Wiggin and Bonner. But they figure the dangerously overvalued housing market will create the most damage."
Now consider this, the "Bureau of Tortured Statistics," in its infinite wisdom, excludes housing prices from its Consumer Price Index (CPI) calculations. Instead it uses "owner equivalent rents." Obviously, with the surge in home ownership, driven by artificially low interest rates, "rents" have become depressed. Notionally, if home prices (instead of rents) were included in the CPI, inflation would currently be above 5%. Moreover, if you add food and energy (non-core CPI) to the equation, the CPI ramp-rate is even higher. If true, this implies that despite the Fed's two-year rate ratchets, we remain in a negative "real" interest rate environment since the inflation rate is arguably above the Fed Funds interest rate. The implication is that the Federal Reserve may keep raising interest rates until there is a financial accident. That would be consistent with the Fed's historic modus operandi, since every tightening cycle since 1970 has been associated with a financial crisis.
We began thinking about interest rates, as well as our "Ownership Society" (read: debt-ridden) as we read the headline, "Bush Requests Emergency Funding" in last Friday's Wall Street Journal. The article went on to say, "President Bush asked Congress for $92.2 billion in new emergency spending that reflects the double burden of wars overseas and hurricane-recovery efforts on the Gulf Coast. Together with prior funding, the combined cost of Hurricane Katrina and military operations in Iraq and Afghanistan will approach $500 billion by the end of this fiscal year September 30." Ladies and gentlemen, $500 billion is a lot of money to borrow, or as Congressman Everett Dirksen once said, "A billion here, and a billion there, and pretty soon you're talking real money." A few pages later in The Wall Street Journal was another article titled, "Facing Debt Limit, U.S. Taps G-Fund." This article noted, "The Treasury Department began using the G-Fund government pension to avoid surpassing the government's statutory debt limit of $8.184 trillion."
"Debt" is a four letter word that is currently ubiquitous in American society. Over the years we have learned that it is often a good idea "to be where EVERYBODY else isn't," which is why we have no debt. Further, historically it has proven advantageous to own assets in such an environment that possess positive cash flows to service said debt. And, that is why we continue to look for investable situations that possess such metrics. One such situation is Precision Drilling (PDS), rated Strong Buy by our Canadian energy research team, as stated in their February 20, 2006 research note:
"Buy Precision Drilling. Precision is now trading at a 9.5% cash yield, which is the highest cash yield it has ever traded at. Furthermore, Precision will report 4Q numbers before market tomorrow, we suspect that the news will be on the bullish side and may provide some reprieve from market headwinds. In any event, we believe that Precision's attractive yield at current levels should provide some protection from further downside in unit value."
"…The company is seeing NO change to drilling programs from clients with recent gas price weakness – Precision has 800 wells in backlog that they do not have equipment for and will not be able to drill this winter."
"…Margin expansion is continuing – the robust demand for drilling services is continuing to push prices higher. With cost increases being kept to a minimum, margin expansion is continuing."
"…If the winter drilling seasons continues until March 8, the company is confident that results for 1Q06 will be stronger than the record results of 4Q05."
"…Plenty of discussion about U.S. expansion. Precision is currently negotiating with customers for an expansion into the U.S. market (they will likely experiment with one Super Single in the U.S. in 2006). The strategy will be to target niche parts of the market with modern and efficient drilling equipment. Precision did emphasize that any expansion to the U.S. in 2007 will likely be 'with size.'"
"…Incremental to the 17 rigs that will be added in 2006, Precision has committed in 2007 to build a minimum to 3 rigs and potentially up to 15 – all 2007 additions would be incremental to our current forecast."
We also offer for your consideration 10%-yielding, Strong Buy-rated (by our Canadian research team) Petrofund Energy Trust (PTF).
The call for this week
The DJIA (11115.32) has broken-out above a spread triple-top in the point and figure charts. So far said upside breakout has been totally unconfirmed by a like upside breakout by the NASDAQ 100 (NDX/1675.21) or the S&P 500 (SPX/1287.24). Still, an upside breakout is indeed a breakout, and if YOU want to obey the charts, a long tactical (read: trading) position in the Dow Diamonds (DIA) may be purchased with a stop-loss point of 107.20. As for us, we continue to think the equity markets are in a "topping process" and consequently eschew the tactical side (read: trading) of the portfolio in favor of the strategic side (read: investing). We are using situations like PDS and PTF, which we believe are in secular bull markets. Another situation we embrace is our correspondent Credit Suisse's Outperform rating on recently "crashed" Chicago Bridge & Iron (CBI), the leading builder of liquefied natural gas plants for this country. We continue to invest accordingly!
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