Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Jeff Saut Presents: Point/Counterpoint

By

Real estate's price decline in individual "bubble areas" has been quite severe...

PrintPRINT

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.

"Any time you subsidize something you get more of it."
. . . Anonymous


I heard the above quote early in my career on the "Street of dreams" and cannot remember if it was from one of Wall Street's icons like Larry Tisch, one of my mentors (like Lucien Hooper), or the floor traders I used to drink with after the 3:30 p.m. market close at "Harry's at the AMEX." However, it was one of those market "saws" that stuck with me over the years, just like "Shorting stocks is a trading operation, because you can only make 100% on your money, unlike going 'long' where your upside is unlimited!" Yet, to reiterate, "Any time you subsidize something you get more of it" . . . be that subsidized farm crops, alternative energy, welfare, or in this most recent case, real estate.

Verily, the "housing subsidy" was brought about by nearly zero percent "real" interest rates, fancy financing vehicles, no money down schemes, unrealistic appraisals, loose lending standards, generational house price appreciation, a belief that housing prices could never go down, and the list goes on, causing one savvy seer to exclaim, "Can you spell bubble?!" Statistically, however, the new millennium's housing subsidy made sense, for as the National Association of Realtors' (NAR) Walter Molony stated in Grant's Interest Rate Observer, "It (real estate) has never gone nationally." Yale University's Robert Shiller agrees, but points out that, "residential real estate prices, in real terms, rose by all of 66% between 1890 and 2004, or by just 0.4% a year." Grant's, however, takes exception with Molony's "never" by noting, "For 'never' we would substitute 'infrequently' or not since the NAR began keeping score." Grant's further expounds, "In fact, average national house prices posted modest declines in 1964 and 1959, as well as horrific drops in both the early 1930s and early 1940s"

More importantly, real estate's price decline in individual "bubble areas" has been quite severe, as witnessed by Houston's 23% price decline, and California's 21% decline in the early 1990s. From a personal perspective, we experienced a HUGE real estate price decline during the 1973 to 1975 Atlanta "condo crash." While back then, real estate's woes were more of an economic effect than a cause and more recently arguably 30% of the job creation since late 2001 has been driven by real estate (1.4 million of the 4.4 million new jobs), we are concerned about the economic fallout of the current real estate debacle.

Nevertheless, we can also see the bright side of the equation, for as the good folks at GaveKal opine:

"With the slowdown in U.S. housing, the U.S. current account deficit will most likely improve considerably. So much so that 'net trade' will add quite a few percentage points to the U.S. GDP, a development which would make a U.S. recession very unlikely. For years, the perma-bears have warned us that the U.S. current account deficit, and the U.S. real estate 'bubble' were two side of the same coin. To be fair, there does seem to be a nice correlation. And an unsurprising one at that: a housing boom usually leads to a large increase in imports (furniture, cars, white products, etc. . . .), especially in a country moving increasingly toward services.

But if the perma-bears are right, then the current slowdown in the U.S. property market should lead to a large improvement in the current account deficit. We thus need to prepare for a sharp drop in U.S. imports in the next few months...Let us take for granted that the U.S. current account deficit will be 'improving' over the coming months. Some might welcome this news; we see it as a serious source of concern. Indeed, as we have shown time and again, the U.S. current account deficit is the primary source of liquidity for world trade.

Because the U.S.$ is still the reserve currency of the world, and because most trade
exchanges are still priced in U.S.$, a reduction in the U.S. deficit is equivalent to a liquidity squeeze. When the U.S. deficit improves, all of a sudden, outside the U.S., there are less U.S.$ around to grease the wheels of global trade. Money becomes scarcer. Which is why, with each improvement in the U.S. current account deficit, someone who is in debt and/or negative cash, goes bust. From painful, and expensive experience, we have learned that, when the U.S. current account deficit improves, one wants to own little but debt-free assets that generate U.S.$ cash-flows.
"


Under GaveKal's scenario, U.S. investors would likely want to go from being over-weight foreign investments and commodities, to underweighted; and, over-weighted "platform companies" with little debt and strong free cash flows. While my firm is intrigued by GaveKal's insights into the housing situation, and its favorable impact on the current account deficit, we have a difficult time embracing their views on the concurrent impact on foreign markets, and commodities, even though we continue to think the correction in those arenas is not complete. In our view, a collapse in housing prices is a bad "bet" because houses "vote!" Therefore, the powers that be will do ANYTHING to prevent a housing crash. Consequently, our views are more aligned with our economist, Scott J. Brown, Ph.D. (The following are his condensed comments, his full remarks can be found at the bottom of this article.) To wit:

"There is widespread confusion about the role of housing in the business cycle. While housing slowdowns have coincided with broad economic downturns in the past, housing sector weakness has been more of an effect than a cause of recession. Building permits are one of ten components in the leading economic indicators, but housing is not, by itself, 'predictive' of general economic health. Residential construction accounts for about 6% of GDP – a 30% correction would not, by itself, send the economy into a recession. Of course, there are a number of important secondary effects – the impact of the loss of housing wealth on consumer spending, adjustable rate mortgage resets, and a slowing in the net extraction of home equity. Home prices will be sluggish to decline – so we are unlikely to see a sharp unraveling of the price increases of the last few years. More likely, prices will flatten or rise slowly for an extended period.

About $1.2 trillion in adjustable rate mortgages (first lien, second mortgages, and home equity lines of credit) will reset both this year and next. While this seems large, many will convert to fixed rate mortgages (still relatively low by historical standards). For those with resetting mortgages, the impact will be significant, but the aggregate impact on the consumer sector will be moderate. The net extraction of home equity has been a significant force supporting consumer spending growth (amid a lack of job growth in the first two years of the recovery and then in the face of higher energy costs in the last two years). However, while net home equity extraction is likely to slow, it should not disappear completely (again, mortgage rates remain relatively low). As the impact of net home equity extraction fades, job and wage growth should work to support consumer spending growth. In addition, a flattening in oil prices would lead to lower inflation and higher real wage gains, more than offsetting the secondary effects from the housing slowdown.
"


The call for this week: My firm remains in the camp that says no recession (a view embraced for nearly five years), although admittedly the odds of a recession are rising. We also are in the camp that thinks the equity markets are in a topping process even while averring the DJIA could "tag" a new all-time high in the process. Additionally, as stated previously, if forced to make a trading bet right here it would be that volatility is going to rise and therefore believe trading accounts should consider going long the Volatility Index (VIX). Moreover, while "shorting" is a trading operation, for investment accounts a prudent hedge to your long positions would clearly be some short positions. In past missives recommendations have been made on a number of long/short mutual funds to achieve this goal. There are also a number of new "short" ETFs (Exchange Traded Funds) for the various indices (call our Closed-End Fund Research Department). As for me, I think The Prudent Bear Fund (BEARX) makes a lot of sense since David Tice & Associates do research on individual stocks to "short" in an attempt to add value over and above just the shorting of indexes. And, to the 16 friends I lost five years ago . . . I still miss you!

Full comments from Scott J. Brown, Ph.D., Senior Economist –

"There is a widespread confusion about the role of housing in the business cycle. While housing slowdowns have coincided with broad economic downturns in the past, housing sector weakness has been more of an effect than a cause of recession. Building permits are one of ten components in the leading economic indicators, but housing is not, by itself, "predictive" of general economic health.

Residential construction accounts for about 6% of GDP -- a 30% correction would not, by itself, send the economy into a recession. The decline in residential construction subtracted 0.6 percentage point from 2Q06 GDP growth and may subtract a full percentage point from 3Q06 GDP growth. Moreover, the 2Q drop in residential construction was offset by a pickup in nonresidential construction. Multi-family construction appears to be improving as well, offsetting some of the weakness in single-family activity. So the direct impact will be limited.

Of course, there are a number of important secondary effects -- the impact of the loss of housing wealth on consumer spending, adjustable rate mortgage resets, and a slowing in the net extraction of home equity.

Home prices will be sluggish to decline -- so we are unlikely to see a sharp unraveling of the price increases of the last few years. More likely, prices will flatten or rise slowly for an extended period. Large price declines should be apparent in areas of the country that experienced sharp price increases in the last few years. For those who have been in their homes for a number of years, even a 20% price drop would still leave them well ahead in the game. Those who have bought homes within the last year or two will be the ones to suffer. The sluggish nature of home price corrections means that it may take some time for the housing market to recover fully.

About $1.2 trillion in adjustable rate mortgages (first lien, second mortgages, and home equity lines of credit) will reset both this year and next. While this seems large, many will convert to fixed rate mortgages (still relatively low by historical standards). For those with resetting mortgages, the impact will be significant, but the aggregate impact on the consumer sector will be moderate.

The net extraction of home equity has been a significant force supporting consumer spending growth (amid a lack of job growth in the first two years of the recovery and then in the face of higher energy costs in the last two years). In 1994, net home equity extraction amounted to about 6% of disposable income (vs. about 1% 10 years earlier). However, while net home equity extraction is likely to slow, it should not disappear completely (again, mortgage rates remain relatively low). Those who have been in there homes for several years are sitting on significant capital gains that they can tap into if needed. As the impact of net home equity extraction fades, job and wage growth should work to support consumer spending growth.

In addition, a flattening in oil prices would lead to lower inflation and higher real wage gains, more than offsetting the secondary effects from the housing slowdown.
"

< Previous
  • 1
Next >
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
PrintPRINT
 
Featured Videos

WHAT'S POPULAR IN THE VILLE