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Jeff Saut Presents: Continuity of Thought


...will the ongoing collapse of real estate "break the continuity of bullish thought" not only for homeowners, but for the economy and the stock market as well?


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.

Bernard Baruch in his autobiography Baruch: My Own Story, discusses "the curious psychology of crowds which has been demonstrated again and again in history." He refers to Charles MacKay's book Extraordinary Popular Delusions and the Madness of Crowds as:

". . . a remarkable documentation of the unbelievable crazes that have swept mankind down through the ages. No nation has been immune to these frenzies. The supposedly stolid Dutch were overcome by the Tulip Craze, the volatile French had their Mississippi Bubble, while the sturdy English had their South Sea Bubble.

As I read the accounts of these madnesses, I was tempted to shout, 'This cannot have happened!' Yet within my own lifetime I have seen similar deliriums in the Florida land boom of the 1920's and the stock market speculation that led to the 1929 crash. Something of this same crowd madness may have been at least partially responsible for Hitler's rise to power in Germany.

These crowd madnesses recur so frequently in human history that they must reflect some deeply rooted trait of human nature. Perhaps it is the same kind of force that motivates the migrations of birds or the mass performance of a whole species of ocean eels. There seems to be a cyclical rhythm in these movements. A bull market, for example, will be sweeping along and then something will happen – trivial or important – and first one man will sell and then others will sell and the continuity of thought toward higher prices is broken.

'Continuity of thought' – what a wonderful expression that is. It did not originate with me. The first time I heard it was while I was operating in a steel stock which J.P. Morgan was trying to accumulate. The general market was on the rise. Then, while these operations were going on, the stock of Rock Island broke. At the time I happened to be with Middleton Burrill, who remarked, 'That collapse is going to break the continuity of bullish thought.' I had never heard the expression before, but I saw at once that Burrill was right and even though Steel was being supported by the Morgans, I sold and took my profits.

The question my firm poses today is – will the ongoing collapse of real estate "break the continuity of bullish thought" not only for homeowners, but for the economy and the stock market as well? You say, "Isn't collapse too harsh a word?" Well, where you stand is a function of where you sit, and from our "perch" here in Florida, the situation looks bleak. And Florida is interesting because Florida led us into the real estate bubble punctuated by the building of more condominiums than I have seen since the great Atlanta "condo bust" of 1974/1975. Consequently, Florida is a pretty good prism for what is occurring on the "coasts," as well as some of the previously "hot" real estate markets like Las Vegas, Phoenix, Washington, D.C., etc. So what is going on in Florida?

According to our real estate team, during the month of June, Florida existing home sales fell 29% year-overyear. Notable declines included Naples (-48%), Sarasota-Bradenton (-40%), Daytona Beach (-39%), West Palm Beach-Boca Raton (-39%), and Tampa-St. Petersburg-Clearwater (-34%). Further demonstrating the market's weakness, the single-family statewide median sales price of $257,800 exceeded the median price a year ago by only 3%, with markets such as Fort Myers-Cape Coral (-5%), Panama City (-10%), and Sarasota-Bradenton (-3%) showing year/year sales price declines. Additionally, Florida condominium sales declined 35% year/year to 5,241 units, with 12 of the 20 metro areas posting double-digit declines. The weakest markets were Punta Gorda (-97%), Fort Myers-Cape Coral (-66%), Naples (-48%), Sarasota- Bradenton (-48%), and Tampa-St. Petersburg-Clearwater (-47%). Moreover, the median condominium price during the month was $212,500, a 1% decline versus the period a year ago, although nine markets reported year/year declines in median prices. Notable weakness was cited in Fort Walton Beach (-42%), Daytona Beach (-14%), Panama City (-12%), Jacksonville (-9%), Fort Myers-Cape Coral (-7%), and Orlando (-4%).

Regrettably, we can only envision this "homesick" environment getting worse, amplified by the $2.7 trillion worth of adjustable rate mortgages (ARMS) that will reset at a higher interest rate in 2006/2007. This comes on top of the fact that 10% of all home owners with mortgages have no equity in their houses, while 15% of the 2005 home buyers owe at least 10% more than their home is worth. Indeed, the "fancy financing" of the last six years is coming home to roost as reflected in Washington Mutual's (WM) annual report. As reprised in Barron's:

"At the end of 2003, 1% of WaMu's option ARMS were in negative amortization (payments were not covering the interest charges, so the shortfall was added to principal). At the end of 2004, the percentage jumped to 21%. At the end of 2005, the percentage jumped again to 47%. By value of loans, the percentage was 55%. . . . Negative amortization and other short-term loans on long-term assets don't work because eventually too many borrowers are unable to pay the loans down – or unwilling to keep paying for an asset that has declined in value relative to their outstanding balance. Even a relative brief period of rising mortgage payments, rising debt and falling home values will collapse the system. And when the housing-finance system goes, the rest of the economy will go with it."

So yeah, we think what is occurring in real estate has far reaching implications for the economy since for the past few years real estate has been responsible for much of the nation's job growth. Moreover, as the good folks at the Liscio Report note (again from Barron's):

"Each dollar spent on residential construction generates $1.27 in additional economic activity. That's topped only by manufacturing ($1.37) and handily bests the contribution of healthcare (54 to 81 cents, depending on which part of the amorphous field you're talking about), retail (57 cents), and finance (53 cents). Not only [has] the kick from housing . . . been enormously important in recent years . . . but, the actual effect has been far greater since that $1.27 of additional economic thrust doesn't include the hardly inconsequential economic stimulus of remodeling or mortgage-equity withdrawal. Housing's fade seems destined to hurt all the more since nothing else – not capital spending or government largess – seems primed to take up the slack."

So to reiterate, we think what is going on in the real estate market currently has VERY significant ramifications for the economy, as well as the stock market. Last week, however, stocks didn't seem to care as the option expiration induced week left most of the indices we follow 3%-to-6% higher and once again positive on the year. Interestingly, while the S&P 500 and D-J Industrial Average broke out above their respective June/July reaction highs, many of the other indices did not. Also of note is that last week's rally was led by the hitherto lagging tech stocks rather than the previous market leaders, causing one Wall Street wag to lament, "When they run the laggards the overall rally is long of tooth."

Nevertheless, in this business what you see is what you get, and despite a number of upside nonconfirmations by various other indexes, and the low volume, the S&P 500 broke out above the 1290-1296 zone that we thought would contain any rally attempt. That breakout can be seen in the nearby chart from the invaluable service The question then becomes, "Breakout or fake-out?!" If it is a legitimate breakout, the near-term target should be the May highs at 1326, yet we remain skeptical.

The call for this week: Surprisingly, China raised interest rates on Friday to over 6% (6.12%) as the worldwide "rate ratchet" continues. Also of surprise are rumors this morning that major terrorist tactics are planned for the Iranian ultimatum (August 22), all of which has the pre-opening futures lower (-4 points basis the S&P 500). Meanwhile, this week's housing report should shed further light on our "homesick" thesis as we continue to contemplate if this is just a mid-cycle slowdown or something worse. For those of you who believe last week was a breakout, and not a fake-out, we suggest considering Budd Bugatch's upgrade this morning on 3.2% yielding Furniture Brands (FBN).

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