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Economics: Slowing Down or Speeding Up?
New York: October 30, 2006
By John R. Stephenson

Things couldn't be more confusing. The Dow continues to surge while the data from the housing market couldn't be more distressing. House prices continue to slide — down some 2.5 percent in the past year — the largest decline ever recorded. With prices sliding, spooked investors are abandoning the housing market in droves (particularly in the U.S. Northeast), fueling fears that consumer spending may tumble along with house prices.

During the past quarter, home construction tumbled at an annualized rate of 17.4 percent, the biggest decline since the first quarter of 1991. The previous quarter wasn't much better as new home construction tumbled 11.1 percent in the April to May timeframe. With a dramatic slowdown in home construction, the overall GDP growth slowed some 1.12% — the biggest slowdown in more than a quarter century. With house prices stumbling, can it be long before consumers begin to stumble?

The worry is that tapped out consumers, especially those carrying a heavy mortgage, may have to put up more collateral as house prices continue to slide. With more money going toward shoring up the mortgage, consumers (the largest contributor to U.S. GDP at 73%) may have less dough to spend on everything else. Making matters worse is the fact that over the last four years, some 50 percent of the gains in GDP consumption spending have come from home equity withdrawals (using your house as an ATM) rather than good old-fashioned wage gains.

Longer term, the problem could get worse as falling prices make consumers feel poorer. Since 1980, the value of owner occupied housing has risen from $4 to $20 trillion dollars ($8 trillion in the last five years alone). With so much wealth tied up in housing, central bankers are worrying that suddenly "poorer" consumers may stop spending — a big problem for an economy hooked on consumption.

But in spite of the worrying news from the housing sector, life is good. Corporate profits are strong which has resulted in a surging rather than a sagging stock market. Not only that, but so far, the consumer has hung in strong with consumer spending rising in the third quarter (3.1 percent versus 2.6 per cent the previous quarter). Leading the charge (up 8.4 percent) has been a surge in durable goods such as furniture and TVs. While house and auto sales may be soft, just about everything else is selling nicely.

The surge in stock markets may be something of a red herring as the most visible index that has been posting new highs has been the Dow Jones Industrial Average. Comprised of just 30 stocks, the index is constructed on a price-weighted basis. Most other indices are market-cap weighted, meaning that it is an increase in overall firm and index value rather than the effect of a few high-flying stocks that is responsible for higher stock market indices. For the Dow, the gains of late have come from just four stocks and only ten of the thirty are above their January 2000 highs. The rest, some two thirds of the index (twenty stocks) is down 25% or more so far this year.

While corporate America appears healthy, much of the gains have come from overseas subsidiaries where growth remains robust. China alone has been responsible for some 65 percent of global GDP gains in the last three years. With coffers bursting, corporate America is most likely interested in increasing the dividend, share buy-backs or expansions of operations in far-flung locals rather than a domestic hiring binge. This, in part, may explain the current paradox between a surging stock market and a sagging housing market.

For the time being, the stock market is likely to trend higher while the shares of homebuilders will likely continue to weaken. If the collapse in house prices continues to broaden, the news for the economy is unlikely to be good. If the consumption slows and businesses retrench, the stock market is likely to turn south as well.

Companies that should fair poorly if the bad news in the housing sector spreads and spills over to the consumer are companies that produce anything that is a discretionary purchase by consumers. If times are tough, the "nice to have" things are the first to go. While cheap, the stocks of homebuilders are a classic value trap (they look cheap but will likely go lower). Other areas to avoid are producers of gypsum, copper and lumber since slumping house sales have weakened the demand for these products.

Investors looking to profit in the months ahead should take some profits in the more growth oriented stocks in their portfolios and consider investing in one of the more defensively oriented sectors of the market (utilities, financials and consumer staples) which have historically done well as the economy slows.

Another area to consider is stocks with high dividend yields. Academic research has established that high dividend paying stocks have outperformed growth stocks (e.g. technology stocks) over a very long period of time. By getting a fair portion of your capital back in the form of dividends, investors are being paid to wait for sunnier days in the stock market.

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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