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Markets: Housing: Ripe for a Fall?
New York: May 02, 2005
By John R. Stephenson

All good things eventually come to an end. For a while, stocks have been on a tear, but in the last few weeks, the reality of an overvalued market with few catalysts in sight has started to set in. Just this past week came news that the economy had grown at a paltry 3.1 percent in the first quarter, the slowest pace of expansion in the past two years - bad news for a stock market that has been hooked on an easy money policy.

But it isn't just the stock market that has been driven up on the backs of historically low interest rates - the housing market has also soared as investors have looked towards real estate as a sure way to make money. So many investors have been piling into real estate that U.S. house-price inflation has surged to a twenty-five year high. The question for real estate investors is: can the party continue?

To keep spending on everything from big screen televisions to larger homes, U.S. consumers have gone deeply into debt. Rather than paying for their unbridled consumption from savings and investment, consumers have funded their latest must have purchases by using their inflated assets (houses and stocks) as a virtual ATM to fund an increasing myriad of purchases. Cash as been pulled out of homes ($750 billion in 2003 alone) and stock portfolios at record rates all to keep the consumption binge rocking and rolling. As a result, household indebtedness has surged to nearly 90% of GDP - an all time record.

Figure 1: Consumers Have Used their Homes as ATMs


Source: Phillips Hager and North

But why have investors flocked in droves to purchase stocks, bonds and real estate? Unsustainably low interest rates. Low interest rates serve to discourage income-based savings by underscoring just how paltry the returns available to savers in more traditional asset classes are. In fact, by lowering interest rates to 50 year lows, the U.S. Federal Reserve (central bank) has encouraged investors to migrate to riskier and riskier asset classes in search of investment returns to fuel their consumption binge and retirement. Consumers have responded to this stimulus by bidding up the price of just about every asset in the hopes of selling out before the music stops.

The U.S. economy has always been driven by consumption. But over the years, the percentage of total GDP (economic output) represented by the consumer has crept up from 66% to 71% of total economic activity. But all this consumption has come at a price - U.S. households are saving less than 1.5% of their disposable incomes. With the government sector and the consumers heavily indebted, the U.S. economy continues to dance on the head of a pin, with the elixir being unsustainably low interest rates.

Low interest rates serve to keep at least a couple of balls temporarily in the air. For starters, they encourage the public to continue to consume beyond their means. With financing charges at record lows, why not enjoy today and pay tomorrow? Low interest rates also make it much cheaper for the government to finance its obligations for the current account deficit (imports less exports) which has ballooned to 6.5% of GDP. But low interest rates skew economic outcomes by encouraging investors to seek out riskier assets - such as real estate and high-yield debt products, for potential investment returns.

Figure 2: The U.S. Current Account Deficit Continues to Soar


Source: M. Murenbeeld and Associates

But can this house of cards continue to stand? Probably not. In its zeal to keep the consumption party going, the Fed has kept interest rates unsustainably low. Now they have to find a way to keep a heavily indebted government and household sector out of trouble while trying to support a weakening currency and keep their overseas creditors from bolting. So far so good. While the currency is down against the Euro it has refused to break. As well, our creditors, mainly foreign central banks, have thus far been willing to accept sub-par economic returns in order to continue the strange vendor financing arrangement they have with us. But for how long can this situation continue? For my money, not much longer.

First, we witnessed a bubble in the stock market, then in fixed income products (emerging market and high-yield debt) and finally a massive bubble in real estate. With a massive speculative bubble forming in real estate (particularly along the U.S. coasts), how long can it be before it breaks? If the bubble in real estate were to burst, the resulting loss in wealth could be between $2 and $3 trillion - about the same as experienced when the dot.com bubble burst.

With the housing market more likely to sour than soar, investors would be well advised to avoid the sector altogether. For those investors who are willing to stomach the risks, short selling is one way for more aggressive investors to capitalize on a likely decline in housing. Short selling (or shorting) is a bet that the price of a stock is going to fall rather than rise. A short-seller borrows a stock, sells it into the market and then buys it back - hopefully at a lower price.

Investors looking to profit from a slowdown in the housing sector might be well advised to consider shorting the shares of the sub-prime lenders. These are companies that extend loans to homeowners who wouldn't normally qualify for a mortgage. Lenders such as Capital One Financial (COF-NYSE), Countrywide Financial (CFC-NYSE) and New Century Financial (NEW-NYSE) could be ripe for a fall as interest rates make their inevitable rise and the overly-indebted consumer finally throws in the towel.

 

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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