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As Safe as Houses?
New York: March 30, 2009
By John Stephenson

Things have been looking up lately. The stock market rallied as U.S. Treasury Secretary Timothy Geithner unveiled his long-awaited financial system rescue package. The market definitely has a more positive tone recently, as investors seem to have decided en masse, that the current recession may only be 1982 rather than the economic apocalypse of 1929. While the recent stock market rally is indeed good news, a torrent of forthcoming economic news — most of which is likely to be ugly, may well put a damper on the market's euphoria.

Some of the possible party crashers include a full slate of first quarter corporate earnings results and continued U.S. employment reports. The American labor market continues to struggle with companies scrambling to adjust their head counts in the face of a deepening economic slump that already ranks amongst the most serious in the postwar period. Initial jobless claims continue to hover around the 650,000 mark with continuing jobless claims moving above the 5.5 million mark for the first time ever. But more worrisome than the current slate of bad news may be a more fundamental shift that will undoubtedly alter the investment landscape for decades to come.

The current economic crisis that started with a housing slump linked to loose lending practices in the United States has quickly accelerated to envelop many of the largest financial institutions globally. The institutions most affected by the crisis are the ones that were responsible for the lion's share of the origination and trading of this toxic debt. But as history will soon show, the timing for a multi-trillion dollar bet on U.S. housing couldn't possibly have been worse.

For decades, the conventional wisdom was that an investment in real estate was the soundest investment one could make. Throughout history, a nation's population has continued to increase with each successive generation growing faster than the previous one. That, in turn, has helped to underpin real estate valuations, as new entrants to the labor force bought houses, started families and then eventually traded up as their fortunes expanded. So ingrained is the belief that real estate values will always increase, that both conventional wisdom and investment experts have stressed that real estate is the bedrock for an investment portfolio for both amateur and professional investors.

But behind that seemingly indisputable logic lies a worrisome trend. Ever since the 1970s, the population growth in most of the West has been negative as birth rates have plummeted. The birthrate throughout the OECD now stands at 1.4 babies per female — well short of the 2.1 births per female required to keep the population steady. Nowhere is the problem more acute than Japan where government estimates now suggest that the country's population will dwindle to half its current size within the next seventy years.

The situation in the United States is indeed better, as its birthrate is close to the replacement ratio and heavy immigration, mainly from Latin-America, has helped keep the population relatively stable. In countries where the policy has been decidedly anti-immigration, the demographic profile of decline is similar and shocking. Until recently, most population profiles have been pyramid shaped, with relatively few older people and lots more young people. In countries like Japan , the population profile is beginning to resemble an inverted pyramid, with older people outnumbering younger people. That population profile will have profound implications for health care, economic output and real estate valuations.

Figure 1: Japan 's Population Set to Plummet

Source: International Monetary Fund

America experienced a massive housing boom that saw real estate prices reach the stratosphere. But behind this multi-trillion dollar bet on rising real estate prices was the loosest set of lending criteria ever imagined. The U.S. government actively promoted the notion of residential real estate to anyone who could fog a mirror. In its rush to expand homeownership, the U.S. Congress turned a blind eye to the aggressive and often predatory lending practices that in turn, have spawned the current crisis. Without an ample supply of well qualified home buyers, America 's financiers turned their attention to a segment of society that they had long overlooked — the unemployed, marginally employed or financially illiterate.

On the surface, the dream of a home for every American looked like a great idea. But the loose lending standards that were actively supported by Fannie Mae and Freddie Mac, the two U.S. government agencies, whose mandate was to support home ownership by lending “more generously” to the poor, helped mask a deeper underlying trend. Beneath the steadily rising real estate prices of the last twenty years, was a population base of well-qualified buyers that was slowly atrophying as Western women continue the trend of shrinking, rather than expanding family size. The boom in real estate prices was driven not by solid underlying fundamentals, but rather by loose lending practices that allowed the marginal buyer to enter the market at little or no initial cost. As a consequence, the boom in residential real estate became extended for longer than one could reasonably expect.

Figure 2: The U.S. Population is Struggling to Remain Flat

Source: International Monetary Fund

Savvy investors should look to avoid exposure to the homebuilders and banks with heavy exposure to real estate. When the world begins to grow again, it will be the countries of the developing world that will have the biggest advantage as they have the favorable demographics to expand and grow their economies.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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