Housing Effects on the Economy

The fundamental question in buying stocks is the expected earnings (or cash flow, depending upon the  sector) compared to the stock price.  One compares this to alternative choices like bonds or real estate or foreign markets.  On a risk-adjusted basis, one's asset allocation should favor the undervalued asset classes.

At "A Dash" we believe that U.S. equities, despite a multi-year, double-digit profit expansion, and some market reaction, still reflect intense investor skepticism about future earnings.  The biggest cloud over the earnings picture is the continuing (and so far incorrect) forecast of a recession by bearish pundits, mostly non-economists.

Background

The recession scare has power for three reasons:

1. The argument that problems in housing and credit markets will spill over into the general economy is eminently reasonable and generally understood.
2. Most market participants have memories of the 2000 bubble era.  They connect the recession, which was actually quite mild, with a massive decline in stocks.
3. Investors and traders alike have no fundamental valuation measure.  Many of them have calibrated their measures to the last few years, the period of skepticism.  They do not realize that the stock decline  in 2000 was mostly the result of excessive valuation, not the recession.

Because this is the key market concern, every investor should be attuned to the impact of housing problems and illiquidity in the credit markets.  The most bearish pundits have already called "Game Over" since stocks declined last month as problems appeared.

The Insightful Method

We recommend a more careful look, considering many sources and all of the evidence.  The distinction is not between those who see a housing/credit problem and those who do not.  The difference is one of assessing the magnitude of the effects.  The most bearish analysts see a series of dominoes falling over with an inevitable conclusion.

Most economists instead look for a change in effect at the margin.  Potential home buyers are not completely disqualified, for example.  They qualify for loans at lower levels, shifting the demand curve for housing.  Prices will fall to clear supply -- at some point.  Those with an appreciation for politics and public policy (like us) understand that there will be various responses to help families avoid foreclosures.  Such proposals are emerging.  The governmental wheels grind slowly, but the story will play out over months, not weeks.

The domino theory is easier to understand, and has a powerful influence on investors.

At "A Dash" we do not forecast recession probabilities.  Instead, we choose to look for expert viewpoints from the best sources.  Our role is the guide to the consumer of forecasts, helping readers to see the strength and weaknesses of various research approaches.

A Survey of Opinion

Let us consider several informed sources.

• The Fed.  The Fed Chairman and individual members speak out.  Today's comments by William Poole indicate recognition of higher recession chances, without any clear evidence so far.  The Beige Book, anecdotal evidence from all of the Districts, also shows little spillover to the general economy -- so far.  Frederic Mishkin's Jackson Hole Symposium paper also reflects optimism about the housing effects.  It is important to know what the Fed members are thinking.
• Economists.  Economic forecasts have all deducted something from GDP for housing effects for the last year or so.  Economists are aware of the potential, and adjust accordingly.  We cannot cite everyone, but here are two excellent sources:
  • David Malpass, frequently cited by "A Dash" as having the best feel for the economy over the last several years, has significantly lowered his outlook.  He has raised his recession odds to 35%, but still emphasizes that a softer landing is likely.  He forecasts softer growth in Q1 08, an out-of-consensus viewpoint.
  • Econobrowser, an excellent economics site that we read daily (and now added to our list of recommended blogs) covers the key issues extensively.  James D. Hamilton and Menzie Chinn analyze the current economic outlook and reflect the housing concerns quite aggressively.  While it is a long article, we recommend that readers look at Hamilton's comments at the recent Jackson Hole symposium.
• Experts on credit markets.  David Merkel continues his excellent contributions to our understanding with an article on stress in credit markets.  A key point is his observation that there will --once again, eventually -- be a market for structured finance.  We see this conclusion as quite important.  There is a long-term force to diversify lending risk through securities, making homes available to more people.  Mistakes have been made, but the concept will survive.  The timing is important.
• Experts on lending.  A key to whether dominoes fall is the reaction by those in a position to influence the outcome.  The key participants include the President, the Fed, creditors holding current mortgage obligations, and (eventually) candidates for the Presidency.  The candidate influence may be felt well before the election takes place.  Here are two great perspectives on how the mortgage issues may play out:
  • Econobrowser discusses various policy reactions to the mortgage problem.
  • Matthew Padilla at the Mortgage Insider (added to our list of recommended sites) has the ability to discover the nuts and bolts of the process.  His article on the incentives for lenders to work out loans, and how they can do this, is a must-read.

Conclusion

The housing and credit problems remain foremost for traders.  The market is reacting to worries and looking for Fed action that may not come -- at least not in the way expected by many.

The long-anticipated effects on personal consumption have yet to materialize.  This, and business investment, are crucial to earnings and stock performance.  The best source is Michael Thompson, of Thomson Financial, the experts on earnings forecasts.  Skeptics on the market should view his interview on CNBC where he highlights business capex trends and earnings forecasts.  These are the actual current numbers, and a good test for the bearish predictions.  Readers should compare the data cited to what they see from those forecasting a recession.

The opportunities for investing always relate to fear and greed.  Some observers point to current stock prices, comparing them to the bubble era, and then issue warnings.  In fact, the earnings and economic  potential is much better than it was at that time.  Having said this, it may still be a rough ride for stocks if the Fed does not comply with market expectations.  Traders all seem to think that they know more than the Fed and their economists.

The problem is that the Fed looks at economic data in the way we have laid it out in this article.  Market participants look at dominoes.  This is both the near-term risk and the longer-term opportunity.

Comments

[Bill aka NO DooDahs!]

WEB did better on that house than he did on his Silver or USD trades ...

[RB]

Where I live (Orange County) there are a lot of pretend-rich with affordability about 50% (difficult to say with today's loan terms) above the long-term housing cost/income ratio average here of 34%.
http://www.realestateconsulting.com/hcb.html
Will they hold up -- it looks like those at the margin will pull prices down with same-home prices down about 5-7% over the last one year. There are also some interesting happenings on the new-home scene where those who "bought because the sales reps told them prices won't go down" are now protesting because of the price drops and incentives.
http://www.irvinehousingblog.com/tag/lantana

I've seen stats produced by the OC Register's Jon Lansner and other articles, it seems like flippers were not much of a factor late in the cycle and the primary cause of the runup here is of owner-occupants using exotic loans (Business Week's map of misery to use their description)
http://www.businessweek.com/common_ssi/map_of_misery.htm

One thing though -- in the last cycle, although the housing market topped out in 1990, it wasn't until 1995 that sentiment towards housing really soured.
http://data.lib.uci.edu/ocas/
That was of course a great time to buy a home here and Warren Buffett did (which he sold in September 2005 for a tremendous profit)! Talk about picking both the bottom and the top correctly.

[oldprof]

RB -
Good question, and it certainly seems plausible. As I read the Mauldin piece I found myself wondering about the passage you cite. Some people who took a teaser rate did so because they knew their stay would be temporary or because the anticipated a change in job status. There are many different cases and we have no idea how many fit the stereotyped pattern.

In some areas, people purchased multiple homes for speculation and then tried to rent. This did not work! Presumably it pushed up prices in those areas creating a greater "wealth effect" for other, uninvolved homeowners. I don't see any evidence of that where I live. Do you?

Those who want to see a big wealth effect always go to the reliable ATM machine stereotype. Do you believe that 2% of GDP growth was "wealth effect"?

We need to find some other sources on these topics. Meanwhile, Mauldin's treatment of the employment revisions is incorrect, another thing for the agenda.

Thanks for a great question.

Jeff

[RB]

This from Mauldin's latest:
"...many of the mortgages sold in the past two years only made sense in a housing market that was rising by 10-15% a year."

Is it correct to say that effects on the margin for house prices on the upside as well as downside due to the overextended borrowers affect home prices for all homeowners and with a corresponding impact on the wealth effect related spending pattern?

[Shrek]

"We are suckers for those who help us navigate uncertainty, whether the fortune teller or the "well published" dull academics or civil servants using phony mathematics." - Taleb.