October 2006
If a picture is worth a thousand words, then today's investment markets deserve at least three charts. Our economy is in transition from the recovery that started in early 2003. What happens next will be very telling and will largely affect how investment portfolios will perform in the coming year. Our current stance is very cautious and we like to think it is based on "real live" data rather than a simplistic intolerance for risk.
Naturally, our first piece of data comes from the housing market. It is no secret that housing has been growing in importance for the US economy over the past five years. We've chosen two charts to tell the story here.
The first graphic, entitled "The ATM in Disguise", shows our economy's increasing dependence on US consumers pulling money out of their home equity to keep their spending going. It is (was?) a form of easy money, but unfortunately that source of funds is quickly drying up. What we are concerned about is the affect this drying up process is going to have on consumer spending heading into next year and its overall impact on the economy. It is important to remember that about 70% of our economy is driven by consumer spending. Roughly speaking, another 15% is spending by our government and the last 15% comes from business spending.
Some have estimated as much as 50% to 66% of the cash taken out of real estate from mortgage refinancing activity or home equity borrowing has gone to support additional consumer spending. The graph shows the impact on overall economic growth without the support of this "ATM" effect. Clearly, it has had a big impact on the way up and we believe it will have a significant impact on the way back down. Just going back to normal will be a tough transition.
Another chart, entitled "The Housing Picture", is also an element that has caught our attention when we look at the housing market. As many know, starting in early 2001, the Federal Reserve lowered interest rates dramatically to stave off an ever deepening economic slowdown. These interest rate cuts along with tax cuts worked to lessen the pain. But, it also likely fueled a booming real estate market that is emerging as a major concern today.
As you can see from the chart, in less than a few months time, the recent trend of home price increases have ground to a halt. Many consumers have grown accustomed to their home values increasing at a 7% annualized rate since 2001.
With housing prices stagnating we're also seeing the number of existing homes sold down over 10% from last year. And the final piece of data shows that the inventory of homes waiting to be sold has skyrocketed to over seven months worth of future sales. This is a pretty ugly picture that is emerging.
Either the number of transactions is going to continue drop with prices holding steady or the number of transactions is going stop falling because prices will fall. Finally, we do grant that it is also a possibility that a number of people are going to give up and pull their houses off the market. We would argue that even that scenario isn't going to allow real estate to provide the economic stimulus it once did.
With a graph like this, something has got to give and when it does, it is probably going to change the economy in a pretty big way. The rebalancing is happening as you are reading this article - in real time. And the capital markets are reading the signs a little differently.
And that brings us to the final chart that we have been monitoring lately, "The Leading Economic Indicators".
While the broader stock market flirts with all-time highs, the bond market is looking six to twelve months out and it appears to anticipating a rather healthy slowdown on the horizon.
One piece of data that has been very good at forecasting economic slowdowns and recessions is the index of leading economic indicators. It is essentially an index of items that tend to turn up and turn down a little ahead of the current economy.
Today, as you can see, we are seeing the index fall rather quickly as the housing market cools. There is a lot talk about the economy coming to a "soft landing", like the one that happened in 1995. That near miss produced a great return for stock market investors and we think investors are banking on a repeat performance. We don't think the backdrop today is comparable to 1995 in fundamental ways.
Firstly, stock prices were greatly supported by dramatically falling interest rates during that period. Secondly, profit margins were not at all-time highs as they are today. Lastly, back in 1995 we were not nearly as dependent as we are today on the real estate market.
Rest assured, time passes and financial market conditions will no doubt change. We feel that in a year's time, a lot of questions will be answered and the prices of both stocks and bonds will most likely reflect the new reality.
In the meantime, the data is coming in day by day and the stock market seems to be doing a pretty good job of ignoring it all.
Ignoring the signs of a slowdown because it worked out well a decade ago looks like a foolish bet to us today.
Then again, if we're wrong, maybe stocks only go up! Now, wouldn't that be an interesting planet to live on?
Jason P. Tank, CFA
jason@frontstreet.com