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Jeff Saut: Housing Making You "Homesick"?


A credit crunch is when the banks quit lending money. So far, people with good credit can still get a conventional mortgage or loan just as easily as they could two years ago.


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 main point is that – leaving aside important issues of moral hazard from fiscal bailouts– there is now a new and increasing recognition that severe credit and financial distress problems cannot be resolved with monetary policy alone. Thus, if a political consensus were to emerge that some financial support of distressed mortgage borrowers is fair and necessary then fiscal – as opposed to monetary alone – solutions may have to be discussed and implemented. The prospect of home prices falling 10 to 15% and two million plus home owners losing their homes is – rightly – becoming a political issue. And political issues lead to fiscal solutions when there is a political consensus that the consequences of no action can be a severe economic and social fallout from the worst U.S. housing recession in decades."
-Nouriel Roubini

For the last few years I have argued that the housing situation was likely going to get worse. I also roiled against the increasingly complex "fancy financing" vehicles that allowed many home buyers to "lever" into homes they really could not afford. Still, the housing/financing bubbles continued to expand driven by the mantra, "you can't lose money in real estate." As with all bubbles, however, this one too has burst.

Nevertheless, I have opined that historically real estate has never pulled the economy into recession since it is an "effect" and not a "cause." For example, in the early 1970s I moved to Atlanta and considered buying a $200,000 condominium. By 1975 that same condo was selling at bankruptcy auction for under $30,000. What happened? Well the "cause" was a rise in the price of crude oil with a concurrent rise in interest rates. The "effect" was a crash in real estate prices accompanied by a severe recession. Therefore, to think that real estate is going to pull the country into a recession one has to believe real estate has become so entwined in the economic fabric of the country that it has morphed from an "effect" into a "cause."

While I am not there yet, I do believe the odds of a recession have risen. Indeed, if the pundits that told us at the beginning of this year there was a 15%-20% chance of a recession were anywhere close to being correct, the odds of one have now clearly risen. In fact, according to some econometric models the odds of a recession are currently more than 50%. Plainly the country's intelligentsia is worried as the Federal Reserve cut the discount rate a few weeks ago and took some pretty unusual "collateral" steps to help shore up the asset-backed commercial paper market (ABCP).

Those measures were designed to grease the rusty wheels of the credit system and allow the major banks to increase the amount of capital they can lend to the broker-dealer (B/D) complex, which is where much of the problem resides since the securitization of loans has transferred the risk from the banks to the B/Ds, hedge funds, etc. Interestingly, however, there has been only a token amount of borrowing at the discount window, suggesting that the banks seem to be more willing to tighten credit than to open the "money spigot."

Such actions have raised cries of a credit crunch; however, I have argued that it is more of a "collateral crunch" than a real credit crunch. Verily, I have lived through credit crunches and by my pencil we are not yet in a true credit crunch. A credit crunch is when the banks quit lending money. So far, people with good credit can still get a conventional mortgage or loan just as easily as they could two years ago. The risk is that the contagion spreads and morphs the collateral crunch into a full-blown credit crunch.

As stated, "plainly the country's intelligentsia is worried" about that potential sequence given the Fed's actions punctuated by last Friday's "Presidential Proposal" to stem the home foreclosure situation. Said proposal would allow homeowners with good credit who have fallen behind on their mortgage payments, due to higher interest rate resets, to apply to the FHA to refinance those mortgages. With the one-year adjustable rate mortgage (ARMs) interest rate jumping to its highest level since 2001 (6.51%) last week, and facing a burgeoning bulge in ARM resets over the next 12 months, is it any wonder the President acted? Regrettably, some believe these new provisions could expand the current 160,000 FHA qualifiers by a mere 80,000 in an arena that has 2 mln subprime mortgages. Consequently, it is doubtful the President's proposals will have much impact.

So why is everyone so worried? Well, in addition to the recent seizing up of the ABCP market, which comprises 50% of the over $2 trln commercial paper market, this housing cycle looks different than any I have seen. To this point, I have included two charts. I suggest studying them carefully. What you find is that the 1988–1992 housing cycle peaked in the first quarter of 1988 (1Q88) followed by a decline in "For Sale Inventories" until the cycle troughs in the 4Q '91 (some 15 quarters later, which is typical).

Click here to enlarge.

Source: Raymond James research.

Click here to enlarge.

Source: Raymond James research.

Scarily, the current cycle peaked in the 1Q '04, yet inventories have continued to rise, hitting an all-time high in 2Q '07. And they are still rising! Moreover, in the 1988–1992 cycle vacancy rates among single family homes for rent stayed relatively flat. In this cycle they have risen dramatically. How this plays out is anyone's guess, but clearly somebody is pretty worried.

Not so worried, however, is the D-J Industrial Average (DJIA), which had gained 5.6% since rumors of the discount rate cut swirled on August 16 into last Thursday's close, and then added another 119 points on Friday, driven by the President's proposal. The result is nearly a 7% rise for the senior index since the envisioned selling-stampede ended. Students of the market should know that a 7% "throwback rally" is about all you typically get on the initial rally following a selling-stampede low. Furthermore, despite all the upside antics the three major averages (DJIA, S&P 500, and NASDAQ) have not been able to better the intraday highs that they recorded on August 8th at 13696, 1504, and 2628, respectively. While the NASDAQ continues to act better than the other two, all three indices are now in short-term overbought territory. Also worth noting is that despite five 90% downside days (total points and breadth recorded were 90% negative) since the markets' peak on July 19, the markets have still not recorded the kind of oversold readings associated with a major bottom.

Consistent with these thoughts, I continue to treat the August 16 lows as an "internal" low and hopefully a low that will stand up during any subsequent downside retest. As often stated in these missives, "Bottoms tend to be a process taking both price and time." Unless the economy morphs into a real credit crunch we have likely met the "price" requirement with a 10.7% correction in the DJIA and a 14% correction for the Russell 2000. Therefore, the "time" parameter is in question since we are only two weeks away from the August 16 "panic low."

While I don't know if this market will follow the patterns of the 1990 and 1998 selling stampedes, whereby the lows were retested in the September/October timeframe, I do believe that many individual stocks made their respective "panic" lows in August. I also believe over the long-term the themes that have served me so well over the past six years will continue to "play" whether the economy experiences a credit crunch or not. Those themes remain: "stuff" (oil, gas, coal, base metals, precious metals, etc.), defense/homeland defense, water, rebuilding the electric complex, agriculture, healthcare, international investments, gaming, RFID, videoconferencing and post-secondary education.

For the mutual fund and ETF (exchange-traded funds) investor there are a myriad of vehicles to choose from that play to my themes. For the stock investor, the following names from the Raymond James research universe include: Covanta (CVA); Pfizer (PFE); Johnson & Johnson (JNJ); L1 Identity Solutions (ID); Harsco (HSC); NII Holdings (NIHD); and Wesco (WCC), to name but a few. I favor a scale "in" buying strategy, especially on weakness toward their respective reaction lows.

The call for this week: If you want to call the current environment a credit crunch it should be termed an "elite" credit crunch (hedge funds, investment banks, etc.) because it has yet to spread to the "man on the street." And maybe that is what the intelligentsia is so worried about, given the "bailout steps" that are being taken. Surly those steps will cost American taxpayers a lot of money, which is likely why gold rallied $8/ounce on the President's proposal last Friday. I have liked gold since October 2001, consistent with my "stuff stock" theme, and think it has a place in every portfolio. I still feel this way and would note that over that nearly six-year timeframe gold, and gold stocks, have outperformed most of the indices. It will be interesting to see what happens to gold, as well as all of the markets, when the "pros" return from vacation this week.

A final observation: "Curiouser and curiouser," cried Alice as she followed the rabbit down the hole... and in addition to the curiouser and curiouser action of T-bills, whose yield recently collapsed by an unprecedented weekly amount totally unconfirmed by a similar decline in the LIBOR rate, for the first time I can recall in nearly 40 years of looking, the Fed's "free reserves" reading was negative (-499) last week as seen in Barron's "Market Laboratory" on page M65.

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