Mauldin Letter
A Ceiling on Housing Prices
Mid-Year Economic Forecast
The Dollar is the Joker
No Fed Rate Cuts This Year
Debt Deflation a Possibility
Stock, Bond, Gold and Much More
By John Mauldin
"The time has come," the Walrus said, "to talk of many things." This
week we talk about whether we are in a housing bubble, look at stock
and bond market directions, the problems with the dollar and much
more. It is that semi-annual time when I make predictions (which is
the term for educated guess), and then watch to see what actually
occurs.
This week I begin with a look at the housing market. I probably get
more questions on housing and real estate than on any topic, other
than stocks. I am going to try and do a quick analysis, and then let
that be the jumping off point for my economic predictions.
There has been much written about the fact that we are in a
potential housing bubble. Typical of the concern is that voiced by
Business Week: "Call it the double bubble. A housing bubble may be
developing--right behind the Nasdaq bubble.....In fact, falling
equities have led many well-heeled investors to shift money into
residential real estate. Robert J. Shiller, author of Irrational
Exuberance, which predicted the Nasdaq crash a year before it
happened, now warns that a psychological frenzy not unlike tech
mania is gripping housing. It appears that the Federal Reserve's
dramatic rate-cutting campaign to revive the economy may be
overheating housing."
Let's set the stage: The total price for all homes in America was
$6.6 trillion dollars in 1990. The collective value of homes rose by
another trillion over the next five years, and since then has
exploded to $12 trillion. There has been a rise of 20.9% in just the
last two years. (EIR)
We are spending more and more of our income on housing. The ratio of
after tax income to the total real estate valuation is at its
highest level in 50 years. Total outstanding mortgage debt is $5.7
trillion, or about one-half of total home value. 60% of today's
families cannot afford/qualify to buy an average home. By some
measures, it takes roughly twice the income to buy a house today as
it did 40 years ago.
The strong housing market gave homeowners a safe-haven during the
recent economic storms. For instance, the national average price of
an existing single-family home is now $192,400. A year ago, the
average was $179,500. For new single-family homes, the national
average price is now $226,800, while a year ago, it was $205,500.
The increases have created a sense of economic security, the so-
called wealth effect. (ABC News)
A Ceiling on Housing Prices
Let's look at what has led to the recent run-up in housing prices
and see whether that is sustainable.
First, one primary driver is lower mortgage rates. A drop of 2% in
mortgage rates lowers the monthly payment of a median house by
almost $300. Conversely, if a family can afford to make $1500
monthly payments, they can now buy "more" home for their monthly
payments. Mortgage rates have been dropping for over ten years. This
increases demand, and thus prices rise.
As noted above, people see housing as a safe investment. Many buy
"too much home" as a "forced" way to save money. Since homes have
risen in value, especially of late, this seems reasonable to the
average home buyer. Since for much of America, the bulk of their net
worth and the greatest increase in their net worth is in their
homes, it only makes sense to them to keep doing more of the same.
Demographics have led to rising values. There are more people
wanting to buy homes, and even though home building has stayed at a
feverish pace throughout the last recession, the supply of homes
available is still historically low.
Two other factors contributed significantly. Mortgage banks created
new classes of loans available to first time buyers and those with
problem credit histories. The number of people who can now qualify
for home loans has exploded. These families buy smaller homes which
cost less, thus driving up prices at the lower end of the market and
allowing those home owners who sold and now have large equity to
move up to a higher priced home. This is not a bad thing, but it is
a real driver on prices. Secondly, low unemployment levels have
fueled demand.
I believe most of these growth factors have run their course. Rates,
while they could drop some more (and I think they will at some
point), are not likely to drop another 2%. There is not much fuel
left in that engine. Demographics, while still positive, do not
suggest that demand will be as big in the future. There are no new
classes of potential borrowers on the horizon. We have made loans
available to almost anyone who can demonstrate economic viability.
But does this mean that like the Nasdaq we will see a bubble burst?
I don't think so, and for the following reasons.
First, a home is an altogether different type of asset than
Amazon.com or Cisco. We can live without the latter, but we all
have to have a place to hang our hats. While the demand for
Amazon.com stock is very elastic, the demand for housing is
universal.
Further, Amazon.com stock can be created quite easily, and for very
little real value. Homes are not created easily, and there is an
intrinsic replacement value to a home.
As our population increases, the demand for housing will increase as
well.
This is not to say that homes cannot fall in value. When and if in
some future time interest rates rise by 2-3%, you can bet home
values will drop. It is not inconceivable that prices could drop 10-
15% or more, as they have in the past because of rising interest
rates. But they are not likely to drop 50% in all but the most
doomsday scenarios. I think doomsday is quite unlikely.
But we may have reached the top in terms of significantly
compounding home prices. If homes were to rise in value by just 7%
per year (forget about 10%), in ten years that means the value of
our homes would double. If incomes were to grow at 3% a year, the
portion that we allocate to housing would have to rise by 50% to be
able to buy the same house.
That is fine if you buy your home today, lock in your mortgage rate
and watch your income rise over time. But when you go to sell in ten
years, a person who makes the same as you do would have to be
willing to spend a great deal more of his income to buy your home.
If your home cost you 25% of your income, your prospective buyer
would have to be willing to spend 37% of his income, or he would
have to make a lot more than you do.
On the average, that is not going to happen. (I will mention
exceptions below.) We are at an all-time high in the percentage of
our incomes we spend on housing. How much more can it grow? We are
also at all-time debt personal debt levels. We have just about
reached the end of the road.
I think growth in average home prices is going to be limited to
inflation plus growth in real income over the next decade, at best.
The key factor in the future growth of housing prices is going to be
affordability.
The next recession could bring about an altogether different result
in the housing markets as opposed to this last recession. Normally,
recessions cause home prices to drop, as more homes come on the
market, and there are fewer buyers. Those of us who live in Texas
experienced the pain of being in a regional recession and watching
our housing values drop significantly. It was not fun to bring a
check to the closing table in order to get someone to buy your home.
So, when you write and ask me if you should buy a home in (your
town), what do I say? I never answer that question. It all depends
upon local situations, and I don't know your local conditions. How
stable is the local employment? How well will your local economy
weather the next recession? Are people wanting to move to your town,
or is there a net drain of buyers? Is there reason to think local
businesses are likely to expand employment? How long do you want to
own your home? The longer you will stay in your home, assuming your
income is stable, the less problem you will have.
Plus, how desirable is the home you want to buy? If it is one of a
kind Maine beach front property, as long as there are rich people,
there will be a demand. (Hint: there will always be rich people.
Like the poor, they are always with us.) If it is a home in the
suburbs, where there are 50,000 homes just like it, then you have to
carefully consider the future economic stability of your area.
But you can no longer buy a home and expect it to grow by 7-10% a
year in value just because it is a home. While there will be places
where this happens, they are going to be the exception. We are
bumping up against our income limits. Buying a home and hoping to
flip it in 2-3 years is going to become a dicey proposition.
That is not to say you should not buy a home. I sold my home a few
years ago, and now lease. I intend to buy another in a few years. I
am waiting, because the home I need in two years will be much
different than the home I need today. When I buy, I want to be in
that next home for some time. I do think homes are reasonable
purchases. But I am not expecting to see it double in ten years, nor
do I intend to sell soon.
One final thought. In just a few years, the Baby Boom generation
starts to hit retirement age. We will not all be able to sell our
homes and move to Florida. The amount of used homes on the market is
likely to increase over the next decade, and this will put a further
ceiling on rising prices. It does not mean that prices will drop,
but it will limit price increases for used homes.
Mid-Year Economic Forecast
The above scenario is just another reason I think we are in for a
decade of below average economic growth. Long time readers know that
I believe we are in a Muddle Through Economy, where growth will be
in the 2% range.
I think the likely scenario is that we slow down from the torrid
growth pace of the last 6 months over the remainder of the year, but
do not think we will fall into a recession this year.
The economy is still growing, although clearly losing some of the
steam from the first quarter. My Three Amigo indicators are all
weak. Capacity utilization is in the 75% range, well below the 80%
that is a sign of a healthy economy. Below 80% generally means that
businesses do not have the ability to raise prices. High yield bonds
are in the worst shape of recent memory. The ISM index, which shows
manufacturing growth, is moving up well, although growth has seemed
to level off and will be down this month. The Leading Economic
Indicators, while still in positive range, have reversed
significantly in the past few months.
This all points to slow growth. I received a little flack from some
readers when I was maintaining that position after the robust first
quarter numbers came in. It now appears I was right on target.
This means profit growth is going to be less than analysts predict,
as most are assuming 4-5% growth for the year. Thus earnings will
not rebound as fast, and that will put pressure on stock prices for
the remainder of the year.
That scenario is mirrored by one of the smartest manager's on
record, former GE chairman Jack Welch. Here is a direct quote from
the NY Post: "There are a lot of people still wondering if this
recovery we saw in the spring was just filling the inventory basket
again, that had been depleted. And nobody is feeling very bullish,"
says Welch.
"There's lots of capacity. Lots of global capacity," he says, and
this goes a long way toward explaining why American companies aren't
inclined right now to build more factories to compete with cheaper
foreign manufacturers.
"You ought to take a trip to Asia and see how much was built up in
the go-go days. There is enormous capacity. Just enormous. Tons of
capacity everywhere. Thailand. Malaysia. Taiwan. Now China.
"There is not a lot of reason to spend on manufacturing," Welch
concludes. "Everyone has too much capacity. Can you think of an
industry in shortage right now?"
"And the economy's problem isn't a function of interest rates right
now, Welch says. With 11 rapid cuts in rates by the Federal Reserve,
money is cheap enough for companies that want to borrow. American
companies also have the added problem of not being able to raise
prices. So, executives have no faith that their profit margins will
improve from current poor levels. A few industries do have pricing
power, like insurance and health care. "But look at widgets," says
Welch. "Any type of widget." Prices haven't risen.
"My concern is, can you get a real recovery without a business
recovery? My own guess is no."
It's amazing how candid you can get when you are not responsible for
propping up a stock price.
Welch makes one good point. Money is cheap, but bank lending to
business is down almost 8% in the last year. It has been dropping
steadily every month, even as rates come down. It is a very anemic
recovery when bank lending continues to drop.
My guess is that the stock market will continue in a sideways to
down trading range for the remainder of the year. That is not
because I think valuations are reasonable (I don't), but because
much of the investing public does. If they did not, you would not
see rallies like those we have seen in the past few days. It
typically takes years for a complete capitulation to develop. We
are just in the third inning of this secular bear market. There is a
lot of game left, and Mr. Market loves to drag out the inevitable.
The Dollar is the Joker
Early in the first quarter, I began to write that the dollar was at
risk, and shortly thereafter, the dollar began to slide. My scenario
was for the dollar to move to parity with the euro by the end of the
year, and to more or less maintain itself against the yen. The
Japanese made it very clear they wanted a weaker yen, and I trusted
that they would be able to destroy their currency.
The dollar is now almost even with the euro, and the Japanese seem
helpless in trying to maintain a lower yen. I have pointed at that
the Japanese government is the only management team in the world
which makes Xerox look competent. This latest failure, when they
can't even print money fast enough to maintain the dollar-yen ratio,
is just another example. This latest dollar drop is moving too far,
too fast. If it keeps up this pace, it is a true threat to global
economic stability.
But not every currency is rising against the dollar. The Brazilian
real and the Mexican peso, as is much of Latin America, are setting
all time lows as I write. Greg Weldon points out that if you are a
Swiss or German investor in Brazil, you are down 60% in just the
last few months.
Weldon is one of my favorite analysts, as he has a knack for seeing
a crisis brewing. He now looks at Brazil and sees serious problems.
The country owes $275 billion, and is far more important to the
region than Argentina. But the country looks increasingly likely to
default on some of its debt, especially as the currency keeps
dropping.
Last year, I wrote about how a dropping yen was exporting deflation
to the rest of the world. Now, a dropping dollar is exporting our
deflation to the rest of the world. While a dropping dollar may help
the Fed in its effort to keep us out of deflation, it does not help
the rest of the world, especially a world in which we were the
engine of growth. We will not be that engine, and that means much
slower growth for the world.
Today we read that US consumer spending dropped for the first time
in six months. Headlines from around the world show consumers
increasingly becoming more cautious in opening the wallet. Nothing
is falling off the table, just a slowing down in growth. More
evidence of a Muddle Through World.
Debt Deflation a Possibility
The risk to my Muddle Through prediction are plentiful, and they are
almost all to the downside. While the US economy has a habit of
surprising to the upside, I am finding it hard to find any evidence
that it will, which is of course why it will be a surprise.
But the risks to the downside are numerous. The threat of debt
deflation is foremost, as all forms of consumer debt are at very
high levels, and consumers are two-thirds of the economy. The
respected Bank Credit Analyst writes:
"This raises the specter of a debt deflation, where the combination
of high indebtedness and falling prices trigger a highly destructive
self-feeding downward spiral in activity. Deflation becomes a
dangerous force when it undermines the ability of individuals and
companies to service their debt. Deflation can cause declines in
nominal incomes and in asset prices, but the nominal value of debt
does not change. This may result in forced selling of assets in
order to make debt payments, unleashing a vicious spiral of falling
incomes, imploding asset prices and even greater real debt burdens.
Meanwhile, even if monetary policy is eased aggressively, deflation
can cause real rates to increase. When there is deflation, a central
bank cannot engineer negative real rates. "
The renowned Yale economist Irving Fisher described the
destabilizing interaction of deflation and debt in his famous 1933
article "The Debt-Deflation Theory of Great Depressions". In
Fisher's words, "the very effort of individuals to lessen the burden
of their debts increases it, because of the mass effect to
liquidate". That leads to what Fisher called the great paradox and
the chief secret of most, if not all, great depressions: "The more
the debtors pay, the more they owe. The more the economic boat tips,
the more it tends to tip. It is not righting itself, but is
capsizing".
"Are there any signs that such a scenario is unfolding? With the GDP
price deflator only 1.3% above year-ago levels, it is not far-
fetched to speculate that deflation might unfold. The goods sector
of the economy has faced deflationary pressures for years, but this
has been offset by sticky inflation in the services sector. However,
inflation in services is now slowing and this trend would intensify
should the economy fall back into recession. Debt deflationary
dynamics could perhaps unfold even if aggregate price levels did not
decline. For example, a major drop in house prices could be the
trigger for serious problems given that home mortgages accounted for
almost three-quarters of the increase in household sector debt
during the past five years. A broad-based fall in home prices would
be a more potent force than lower equity prices in terms of
undermining consumer balance sheets. The Great Depression was not
caused by the stock market crash but by a series of serious policy
errors, including overly tight fiscal and monetary polices and the
introduction of protectionist trade polices. The Fed is not making
that error in the current cycle, and rates will be cut further if
necessary."
BCA printed the above to deal with questions from their clients and
answers that they feel the risk, while not negligible, is small.
They are still more bullish than I am. But this is an important
topic, and I will deal with it extensively next week.
A second risk is if the dollar continues to drop at the rate it has
in the past few months, this could be a serious problem.
At the very least, the drop in the dollar does not portend well for
the US stock and bond markets, as European investors are down over
25% on their US stocks (S&P 500) this year, half from stock losses
and half from currency losses. How attractive are US treasuries at
2-4% if the currency is dropping 10% or more a year?
What is holding the dollar up? Many central banks, primarily Asian,
are buying large amounts of dollars in an effort to keep their
currencies from rising and making their products more expensive to
the American consumer. One wonders how long they will keep it up?
Put on a percentage basis, I think there is a 5% chance of a
surprise to the upside, a 20% chance things get worse this year and
a 75% chance we Muddle Through. If the dollar continues to slide, I
would increase the odds of a dip back into recession to 50% this
year, and much higher for next year.
Gold will continue to rise as the dollar falls. Oil is in a sideways
to down trading range, as Russia increases production and demand
falls off. Most commodities will be sideways.
No Fed Rate Cuts This Year
As I have repeatedly said, the Fed will not raise rates this year.
Greg Weldon thinks it is more likely they will cut rates, and this
week I am beginning to read in several disparate sources that very
same speculation. Even BCA (above) noted the possibility of rate
cuts. This is far different language than anyone read a few months
ago.
What could cause the Fed to cut rates? If their very clear campaign
to reflate the economy starts to fail, I think they might get
worried and cut. When BCA starts to write about debt deflation, even
to tell their clients they don't think it will happen, it raises a
lot of eye brows. You can bet the Fed will do everything it can to
make sure it does not happen here, as it did in Japan.
And lastly, what do I think about bonds? My crystal ball is becoming
increasingly hazy. I am not one for waffling, but there are several
competing factors, and I am not sure which wins out.
Don Peters, with one of the best bond management records I know of,
thinks long rates are going down, primarily due to deflation. But
then he has thought that for a long time. Inflation is low, and by
historical levels, long term bonds should be around 4%.
But they are not. The market seems to be unwilling to let long rates
drop all that much, as they continue to think in terms of inflation
returning. Couple that with foreign investors leaving, and that does
not portend well for long bonds.
But the Fed wants long rates to drop, and in a rational world, they
should be lower because inflation is now below 1%. Will US investors
plow into bonds as they leave stocks? Remember, however, the markets
can be irrational longer than you have money. In the 50's, rates
stayed lower than they should have for quite a long time as
investors did not fear inflation, and kept investing in bonds as if
deflation would return. Habit can be a hard thing to break.
One place I am bullish is high yield bonds. They are now at the
highest levels in a decade. As they snap back, I think there will be
some good opportunities. My favorite high yield bond timer, Steve
Blumenthal of CGM, has had his clients (and mine) safely in money
markets for many weeks and avoided the recent collapse in high yield
bond funds. For more information on CGM, you can call Wayne
Anderson in my office at 800-829-7273.
Birthday Happenings
Tomorrow my twin daughters, Abigail and Amanda, turn 17. It seems
like yesterday we picked them up from the airport on a flight from
Korea. At six months old, they were still smaller than my two oldest
daughters at birth. They are still smaller, barely topping 4'10".
But they are a large part of my heart. And beautiful, I might add.
Hopefully, we will get all 7 kids to come home and celebrate with
us. Things will be busy and fun at the Mauldin home this weekend.
Last week's letter brought an unusual amount of mail. I always read
your letters, even if I cannot respond to everyone, and I try to
answer as many as I can. I really enjoy hearing from you. Have a
great week, and stay cool.
Your starting to need a vacation analyst,
John Mauldin
John@2000wave.com |
