HOUSE MONEY
by Bill Bonner
“Despite its severity, we believe that the slump in stock prices will prove an intermediate movement and not the precursor of a business depression such as would entail prolonged further liquidation...”
Harvard Economic Society
November 2, 1929
The average man discovered stocks in the 1990s. At first, he thought he had fallen into the Lost Dutchman mine. But in a few years, the paydirt played itself out. Now, he just digs himself in deeper.
Stocks are down an average of 14% so far this year, and down about 30% from the top. So far, the negative consequences of falling stock prices have been offset by rising house prices and the "house money" effect – the money he was losing was never really his in the first place.
Today’s letter, to be continued on Friday, poses the question: how long will this "house money" continue to shelter people from the storm on Wall Street?
"Not very long," is our answer.
Based on the broadest index, the Wilshire 5000, investors entering the U.S. stock market in mid-1997 are now about even. Five years of stock market sturm und drang have left them where they started. No richer. Maybe a little wiser. Certainly older – five years closer to retirement age.
This last detail may be the decisive one. For, when people approach retirement, something happens to them: they become risk averse. A young man – with 60 years of life expectation – will do the damnedest things. He’ll drink a half bottle of good scotch and drive down a mountain road as if he thought he was making a moonshine run. Or, he’ll jump out of perfectly good airplane...Or enlist in the army just when war has been announced.
An older man has few years to lose, but like a shipwrecked sailor down to his last pack of cigarettes, he guards them carefully. He won’t cross against the light...and won’t even have a cup of coffee before going to bed for fear it will disturb his sleep...
Imagine what happens to an economy when millions of people grow old at the same time, dear reader. Well, you don’t have to imagine. You have only to look at what has happened in Japan since 1989...or wait to see what happens in America in the years ahead.
“It amazes me that most people miss the appalling demographics in the Western World,” writes a poster to the Richard Russell website. “This is the thing that keeps me awake at night. By the time a 31 year old retires at 60, almost 50% of the population of the western world and Japan will have retired before him...that is staggering. It should be a long way off but I’m afraid it’s not. The average American is 44 years old, has $40,000 in his 401K and has more debt than at any time in history. He has effectively 10 to 15 years to save enough money to retire. If he wants a retirement income of 2/3rds of his salary then he needs to save something like $500,000 over the next 15 years. I’m not quite sure how he’ll do it.”
How will he do it?
“He’ll either have to retire poor or live like a pauper over the next 15 years. Either way, it’s not inflationary by any stretch of the imagination,” he concludes.
Biology and actuary science converge at around 50 years of age. They soften up a man’s brain and his stomach...and turn him from a dynamic risk-taker into a fretful old coot who won’t part with a penny without a court order.
A man over 50 doesn’t want to wait a quarter of a century for stocks to come back to where he bought them. Rather than take the chance, he typically shifts his portfolio from capital gains to income. His risk tolerance also shifts, from return on investment to return of investment...and his savings strategy drifts too, from just-in-time to just-in-case.
Of course, everything important happens at the margin, as the economists say. The marginal grumpy old man of the ‘90s entered the stock market along with everyone else. Who could resist such a party? So, along he came – dressed for a funeral but hoping for a good time.
If he got into stocks in 1997, his portfolio is now worth about what it was when he bought the stocks. But in the meantime, his debts increased, his savings went down, and the cost of living rose 12% over the past 5 years. So, he’s in much worse shape than the Dow suggests.
“Saving short and overly indebted, the aging American consumer is also closer to retirement, on average, than at any point in the post-World War II era,” writes Stephen Roach. “Moreover, with pension fund regimes having shifted increasingly from defined benefit to defined contribution schemes - assets in DC plans first exceeded those of DB plans back in 1997 - the nest egg now looks more precarious than ever. In addition, the equity culture has become more essential than ever to American households in achieving their life-cycle saving objectives. As President Bush indicated in his 9 July speech on corporate responsibility, more than 80 million Americans now own stocks - either directly, in mutual funds, or through their pension plans.”
Monday’s near-panic on Wall Street could be a sign of things to come. For up until very recently, the average aging patsy felt as though he was playing with "house money". If he had bought before ’97 he was still ahead of the game. It wasn’t his money he was losing, he could tell himself, it was the casino’s money.
Even if he had been holding the big tech – such as Intel, Dell, and Cisco - his positions were still in the black, even after going down 50% to 80% from their highs. But now, the average investor has run out of "house money."
“American households are now hurting big time,” says Roach.
“The American consumer remains at the top of my worry list in this post-bubble era. The reason - the perils of what I have called the 'asymmetrical wealth effect.' This rests on the basic precepts of behavioral finance set forth over 30 years ago by Amos Tversky, a renowned Stanford University psychologist. Through experimental sampling of investor responses to hypothetical and actual financial market situations, Tversky found that the loss aversion motive of individual investors made them far more sensitive to reductions in wealth than to increases in their portfolios. The caveat came in what Tversky called 'prospect theory' - that investor responses are also influenced by recent performance. Individuals that only lose 'house money' are less inclined to alter their fundamental economic behavior. Conversely, once the accumulation of losses taps into original investor principal, it’s a different matter altogether.”
Historical, real returns on U.S. stocks have averaged about 7% per year for the last 200 years. In the mid- to late-90s, investors got used to returns of 20% per year...and more. Now they are five years older...closing in on retirement age...and taking losses – and not just of "house money," but of real money, savings that were intended to cosset gray heads and wrinkled brows.
That these marginal, 50-something investors will panic out of stocks seems a foregone conclusion. Will they panic out of houses too...and out of habit of consumption?
“It is in this broader context that I believe that five years of real wealth destruction have the clear potential to trigger the powerful loss aversion responses first envisioned by Amos Tversky,” Roach explains. “Given the demographic profile of an aging American population, saving imperatives are all the more important. That means American consumers now need to save the old-fashioned way - out of their paychecks.”
When Americans begin saving like the Japanese, should it surprise us if the U.S. economy turns a little Japanese too?
“You have to begin to sell when the householder buys,”
Attributed to one of the Rothschilds
The Fed chairman seemed proud of his work. Speaking to Congress last week, he said that interest rates, driven down to below-market levels by the central bank, had encouraged "households to purchase homes, refinance debt and lower debt service burdens, and extract equity from homes to finance expenditures.”
American households took Mr. Greenspan’s bait. They took whatever money they had on hand, borrowed more from over-eager lenders, and bought what are usually charmless, flimsy, pathetic, sordid, puerile suburban homes. A few of the more aggressive householders began buying and selling them as if they were dot.com stocks. Now, they have plenty of house, not much cash, and they’re on the hook for $2.7 trillion in mortgage debt. What will they want next? More split foyers? More colonials? Ranch, contemporary, Spanish colonial? A McMansion?
Or more cash and less debt?
The average American lives in a suburban house thought to be worth $192,400. Since stocks began to decline nearly 3 years ago, his net worth has not necessarily declined, but it has become less abstract; the poor man now has to live in it. Worse, if things develop as we fear, he’ll have to live in it for a lot longer.
But for now, he is as content with himself as the nation’s Fed chief. His "investment" in his house has done well – far better than an equivalent in the stock market. He does not notice that his castle of 2002 has no moat to protect it from a bear market in housing.
The Daily Reckoning is free. Since you pay nothing for it, we feel entitled to pass along our gratuitous reflections; sometimes readers find more of them in their morning’s DR than in the bathroom mirror.
Readers write almost daily, asking to be taken off our list. Irish, gypsies, gay, straight, Republican, Democrat, frogs – who have we not offended? Tomorrow, we fear...we will hear from the suburbanophiles.
“Single-family homes are selling quickly, prices are soaring, and buyers who square off in bidding wars can end up paying thousands more than sellers have asked for,” says the Philadelphia Enquirer.
“Why the frenzy? Low interest rates are the most obvious cause. When rates are low, buyers can qualify for bigger loans, so they can afford to bid higher. Though rates have been low for two years, many people may be rushing to buy now for fear that rates will rise as the economic recovery progresses.
“But they have another reason to rush: fear that rising property prices will put their dream homes out of reach, even if interest rates stay low. This overeagerness to buy is a classic sign of a bubble.”
A housing bubble in Philadelphia? It seems almost impossible. Who would want to buy a house in Philadelphia...must less at a premium? But house prices are up in Philadelphia, and even some parts of Baltimore. My sister, looking around rural Virginia, reports that there too it is a seller’s market - even in the most benighted areas.
“The five most expensive markets in the nation in order are Boston, where the percentage of income devoted to mortgage payment is 44.9%, San Diego at 43.1%, Fort Lauderdale 29.1%, San Francisco at 47% and Miami at 30.0%.,” adds Richard Russell.
“The old rule was that you spend 25% of your income either on rent or for carrying your mortgage. All of these cities are above 30%. This is just one test of housing prices, but I think it's valid. And yes, I do think housing is in a bubble.”
When the Nasdaq bubble popped, dot.com analysts moved on – to making real estate appraisals. Thanks partly to their accommodating estimates, suburban America is now thought to be worth about 15% more than it was last year at this time...and twice what it was worth in 1990.
This newfound "house money" has sheltered Americans from the decline in stocks. While stocks lost about $5 trillion since the top, real estate is up about the same amount. Our question in this letter is how much longer this house money will hold up. Our answer, as on Wednesday, is "not much."
A poster on Richard Russell’s site: “As a student of bubbles and crashes (am an investment professional who has spent his career in emerging markets), I can tell you that I have never seen a bubble in equities unwound without an unwind in property. For example, Japan, Korea, Hong Kong, the Philippines, Thailand, Indonesia, Mexico, and Brazil. And the unwind generally begins when credit goes south, which happens shortly after an overvalued currency begins to fall, which follows the first leg down of a big, ugly bear market.”
Why can’t residential real estate just continue to rise – even after stocks head down?
John Mauldin explains:
“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% per year, the portion that we allocate to housing would have to rise by 50% to be able to buy the same house.”
It is all very well for the seller. He watches the supposed value of his house rise up like a drunk from the floor of a saloon. For a brief moment, he imagines himself rich...and begins to daydream about the marvelous retirement in the sun he will enjoy on the proceeds of the sale.
But to whom will he sell? With incomes rising at only half the rate (in John’s example) who will be able to buy the house at the list price?
And...who would want to?
"It was the flight to suburbia [after 1929] that smashed land values in the big cities. That mighty blow to the economic centers of the country helped to bring on the Great Depression."
Jack Lessinger
A few months ago a friend, keeping me abreast of the hometown news, sent a clipping.
“La Plata Destroyed by Tornado,” said the news article. The accompanying photograph showed several buildings leveled...with bits of vinyl siding scattered on the ground and fiberglass insulation hanging from a surviving tree is though it was Spanish moss.
The report told how 3 or 4 people were killed when a twister let loose and went through the Southern Maryland town.
“Small price to pay to rid the world of La Plata,” your editor thought to himself. Even the debris was embarrassing. A decent building would have yielded at least a pile of bricks or stone. This stuff was so light the cyclone must have ripped it apart like a child opening a birthday present and carried it across the bay. They’re probably still finds bits of aluminum siding and quarter-inch plywood over on the Eastern shore.
La Plata was once a fairly decent little burg. Your correspondent recalls his first summer job. Working for a building contractor, he was given 5 minutes instruction and put to work painting the new bank in the center of town. As the white paint dripped down his arm, he felt a little pride in having gainful employment and on contributing to a handsome building – for the bank was built on the colonial theme, out of brick with white trim (and the occasional serendipitous splash of white paint on red brick, courtesy of your editor).
Years later, Route 5 coming out of Washington was widened, and in came the commuters, the shopping malls, auto dealers, and almost every imaginable commerce that a man can put a price behind and parking lot in front of. Hamburgers, pizza, Chinese takeout, tacos...muffler replacement, tires, lubrication...once the division of labor took hold, there seemed no stopping it. You had only to drive along in the far right lane, keep your eyes open...and anything you might want would soon appear, advertised on a billboard. And so convenient!
European cities are different from Americans ones: people want to live in them.
Prices in Paris have risen sharply in the last 5 years. A one-bedroom apartment of just 500 square feet sells for $300,000. The closer to the center of town, the higher the price. And no wonder, in the center of European towns, you find good restaurants, movies, bars, clubs, museums – sidewalk cafes and street life. At 6PM on a Friday afternoon, when the weather is good, a person can scarcely find an empty chair at the Paradis across from our office.
By contrast, downtown Washington, at the vesper hour, is deserted.
With a few exceptions, American cities are not places people choose to live. They wouldn’t choose to park their cars downtown either, but it is a necessity. And as soon as working hours are over, they get in their cars after work, roll up the windows, and get on the freeway. But instead of heading to some paradise beyond the city walls, the poor hapless commuter spends an hour in traffic to get nowhere. Driving down Route 5 to La Plata, Maryland, for example, he finds no museums, no cafes, no decent bars, no restaurants with a chef, no charm, nothing but a wasteland of strip malls and insipid houses tracked across the landscape like cogs in a zipper.
Nor are there any public fountains, gardens, grand avenues, parks worthy of the name...no history...and here we offer a guess: no future. Nothing but a desolation of parking lots and forlorn residential cul de sacs where the trees have been cut down so the streets could be named after them. On Dogwood Lane the houses are butted up against one another so a man risks splashing his neighbors when he washes his car. And over on Maple View Drive the neo-plantation style houses begin at $499,000, believe it or not. For the price, you get all the latest popular conveniences – water jets in the bathtubs, cable and alarm wiring, in-ground pool, 3 car garage, decks with barbecue and Jacuzzi, and heck, maybe even a family dog. Just hope that no tornado whips up and blows it all away.
It’s the windows that bother us most. They stick the $499,000 house out in the middle of a tobacco field without even a locust tree for shade...and then nail the vinyl shutters to the wall. You’d think for that kind of money you’d get decent windows you could open...and decent shutters you could close. But shutters went out of fashion in America before WWII. Since then, people just turn up the air-conditioning, draw the blinds, and turn on the TV.
There are probably people who like suburbs. Of course, there are people who like Barbra Streisand and sumo wrestling. Most people look at the suburbs as a necessary evil – like taxes, except that it is an evil they plan to escape...after the kids have left home and their retirements have begun.
Therein hangs a tale, we believe. For suburban real estate represents the number one item on American’s balance sheets – and also their biggest liability. “Real estate loans anchor our whole economy,” writes Jack Lessinger, an economist who specializes in real estate patterns. “In the event of a large and permanent collapse in real-estate values, property owners default on their mortgages, banks and other lenders go belly up, depositors aren’t able to pay their bills, production and consumption slow down, unemployment rises and government is helpless because bailouts would be too expensive.”
As America’s love affair with stocks began to turn a little sour, investors slouched back to their homes...and looked upon them with new favor. Every passing day, the stock market seemed to get older and uglier. But the real estate market never looked finer...for every dollar their equities had lost, their homes seemed to gain one – or almost. In the last five years, stocks rose by $6 trillion...and then gave the money back. The real estate market gained about $5 trillion and still has it in its pocket.
And Greenspan’s low rates made it possible for a homeowner to borrow out some of his “equity”...and still end up with lower monthly payments. The consumer not only did himself a favor by buying a new house – or refinancing an old one – he gave a boost to the entire economy. And Greenspan applauded his efforts on national TV!
Houses, like automobiles, are considered "durable" goods. They are meant to last. Automobiles lose value at a notoriously fast speed. Until now, houses have generally increased in price. Nothing says they have to; suburban housing prices, in particular, may prove much less durable than people expect.
Lessinger believes the next major phenomenon in the real estate market will be the collapse of the suburbs.
America’s baby boomers are not just getting older and more desperate, says Lessinger, they are also changing their minds about what they want:
“Suburbia is no longer the centerfold of the American Dream...” The boomers want “something quite different,” he continues, “life in a small, friendly community far from congested freeways – a village in the midst of natural and unpolluted open space. And since 9-11 there’s another factor: Dense metro areas make inviting targets for terrorists. As people are increasingly anxious to leave, the demand for suburban real estate is leaking away. When that leak becomes a flood...expect a crash.”
In the early 1900s, one of the surest investments one could have made was in America’s large cities. Rural populations migrated to urban areas to find work...and escape boring lives in hick towns. But by the 1920’s a new trend was already underway – the big cities were filling up with Blacks and Catholics, so those who could afford to were moving out of the center of town to close-in suburbs. The market break in ’29 marked the end, not just of an mania for stocks, but also of in-town property prices. Cities such as Baltimore, St. Louis and Philadelphia hit their peaks around ’29 – and never recovered.
Likewise, Lessinger believes the current bear market on Wall Street will take suburban property prices down with it, permanently. Trendy, fashionable, wealthy people will never again want to live in the suburbs. Which is not to say that the suburbs will be destroyed like La Plata. That is more than we could hope for.
Bill Bonner
Bill Bonner is the founder and CEO of Agora Publishing. He is also author of The Daily Reckoning, a daily e-mail offering "erudite" commentary on the days stock news. Click here to sign up for a free subscription:
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