Housing Bust Housing Bust: The Spectre of Deflation
by John Calverley
The Daily Reckoning
Baltimore, Maryland
Tuesday, December 21, 2004 John Calverley discusses the likelihood and ramifications of a US Housing Bust.
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*** Storm clouds cover Fannie Mae...nothing comes as surprise to us
anymore...
*** The drama continues...what exactly is a "jumper"?
*** The true meaning of contrarian...and more!
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"Fannie Mae storm swirls around CEO," reads a Reuters' headline.
Rarely, dear reader, does a story so succinctly jive with the themes
we explore here at the Daily Reckoning.
The public spectacle at Fannie Mae finds CEO, Franklin Raines,
wonder-boy from a disadvantaged background, facing an "unexpected
twist in his career that had seemed likely to vault him into a
prominent role in national politics."
Of course, this doesn't come as shocking news to loyal sufferers of
The Daily Reckoning:
"While Raines and Chief Financial Officer Timothy Howard said they
believed they were using correct accounting," the Reuters article
continues, "the Securities and Exchange Commission confirmed the
errors last Wednesday and told the company to restate earnings from
2001 through mid-2004. Fannie Mae has warned investors the
restatement could include after-tax losses of as much as $9
billion."
Ironically, Raines is credited with being the first budget director,
a post he held in the Clinton administration, in 30 years to balance
the national budget.
The board governing Fannie might save Raines bacon, but the writing
is already on the wall for CFO Timothy Howard. As the spectacle
unfolds... we find ourselves enjoying our front-row seat. We hate to
say, "I told you so," but...more on this below...
More news, from our team at The Rude Awakening:
--------------
Eric Fry, reporting from the center of the financial universe...
"'If Santa Clause should fail to call, bears may come to Broad and
Wall.' I am under the assumption that a good decline is coming for
stocks, probably right at the start of January...All kinds of gauges
are flashing danger, and just because the market has ignored them so
far doesn't mean it will continue to."
For the whole story, see today's issue of The Rude Awakening:
Scary Christmas
http://dailyreckoning.com/body_headline.cfm?id=4363 --------------
Addison Wiggin, back in Baltimore:
*** What will happen to Raines? We have no idea...and the clammed-up
corporate spokesperson couldn't help us either. He just said that the
investigation was "an ongoing process."
More instructive is this comment from Fed President William Poole,
spoken in March 2004:
"Some crises, such as the one that brought down Enron, are well
contained and do not spread to other firms. Others...have wider
effects. There is no question but that a crisis affecting either
Fannie Mae or Freddie Mac would have widespread effects because these
firms are so large."
Hmmmm...could it be that we weren't the only ones anticipating a
scandal at Fannie Mae? Our very own Fleet Street editor, Chris Mayer,
predicted that the mortgage-lender would crumble in 2005, but it
seems the news beat him to the punch...and it's already happening! No
matter, Mr. Mayer has six more predictions that will astonish
you...and, according to Prediction #1, this won't be the only scandal
in 2005. You don't want to miss this:
Seven Shocking Predictions for 2005
http://www.agora-inc.com/reports/FST/predictC06 *** The Dow hit a new three and a half year high today...
But that's nothing...when compared to the Russell 2000. The benchmark
small-cap index hit a new all-time high at 648 last Friday.
"Small-caps, as they are known in the business," writes a Bloomberg
columnist, "came into the year looking fat and sassy. The small-stock
Russell 2000 index had beaten the big stock Russell 1000 for five
straight years, including a 45.4% to 27.5% shellacking in 2003."
Bloomberg continues: "How convenient, as events unfolded, to see the
small stock index prevailing again in '04, this time by a resounding
2-to-1 ratio through the first 11 months of the year. The Russell
2000 was up 15%, while the Russell 1000 gained 7.5%"
"How convenient indeed," Carl Waynberg might add. Carl is a
specialized small-cap analyst and spends his time pouring over
companies that are so small, they're totally off the radar. What does
he do when he finds a "Jumper?" He takes a large position of course.
So what is a jumper? Addison refuses to tell us. He says it's a
secret and promises to tell us on Christmas Eve...
*** An intelligent comment and argument for a secular bull market in
stocks from a reader of The Rude Awakening:
"Do you want a really contrarian idea? Say this out loud 'We are in a
new secular bull market.' Now doesn't that sound totally absurd and
crazy and go totally against what your gut tells you? Now tell me,
who else have you heard say that we are in a secular bull market? No
one! Look at all the Wall Street forecasts for '05. Not a single
person is expecting '05 to be a big up year for stocks. You want a
sentiment gauge - how about the $1 trillion dollars that have rushed
into hedge funds over the last three years - all people who are
trying to avoid market risk. When everyone is trying to avoid market
risk, it's a great time to start taking market risk. In the bear
market a VIX reading this low was bearish. But if you look back to
'94 and '95, the VIX did exactly what it's been doing lately,
gradually trending down. Then when in fact it did start to rise, it
was because volatility in the market picked up...in a bullish
direction! All of you 'we're in for a decade of low returns' guys all
are saying that rising interest rates are going to pop the debt
bubble because China, et al are going to start selling Treasuries,
yet everyone who's a secular bear is also bullish on Asia. So Asia is
going to boom, they're going to have a bunch more money flowing in,
and they are going to stop buying Treasuries? No, they'll keep buying
Treasuries as long as their countries are doing well, because the
only way they do well is if the U.S. consumer keeps spending. Thus,
there is going to be a lid on the U.S. yields as foreigners continue
to increase their purchasing. So while there is a debt bubble, it's
not going to pop any time soon because rates are not going up.
"I normally enjoy reading your daily email, and I enjoy truly
contrarian ideas (I almost fell out of my chair when I heard you say
that you, a perennial bear, think the dollar is a buy - I think
that'll turn out to be a great call.) However, don't confuse bear
with contrarian. A true contrarian figures out how everyone is
positioned and does the opposite. Currently, all the hedge fund money
is implicitly in the secular bear camp. Even the mutual fund managers
whose job depends on a rising market don't believe tech is going up.
You want to be contrarian - tell me why Ford is a great buy here
(which it is) or why Google and Taser are actually great bull
stories? Do you really think the market is going to crash when you've
got Fortune covers questioning whether Google is worth $165?"
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The Daily Reckoning PRESENTS: The Chief Economist at American Express
Bank takes a look at the global property bubble - and explains why
this is such a "dangerous phenomenon" for the United States. Watch
out below!
THE SPECTRE OF DEFLATION
by John Calverley
U.S. house prices rose 13% in the year to Q3, including an
astonishing 42% leap in Nevada, 27% in California and 23% in
Washington DC. Prices have risen a long way on the coasts over the
last 7 years with gains of 134% in California, 103% in Massachusetts
and 92% in New Jersey and 89% in New York. Inland regions have
generally been more stable so the nationwide average gains since 1997
is a more moderate 65%. Nevertheless, with house price inflation
accelerating, it looks as though the United States is in the
early-to-middle stages of a bubble. In the U.K. and Australia more
advanced bubbles are key factors in economic performance and monetary
policy. The United States is likely to go the same way.
One of the causes of the bubble is that people seem to have forgotten
that house prices can fall as well as rise. And the risks of a
significant fall are more acute now than for over 50 years because of
the low rate of inflation in consumer prices and the threat of
deflation. Between the 1950s and the mid 1990s falling consumer
prices, deflation, was virtually unknown anywhere. The world's
attention was focused entirely on battling rising prices, inflation,
which had become the number one economic problem. But by the late
1990s the battle against inflation was won and deflation had emerged
in several countries in Asia including Japan.
Housing Bust: Deflation
Deflation is a new and troubling threat for all of us, brought up in
an era of continuous inflation. Almost nobody alive today, even the
venerable Mr. Greenspan, was an active market participant or
policy-maker in the 1930s, the last time the United States suffered
deflation. Yet, during the 19th century and right up to the 1930s,
deflation was common, indeed even normal, while inflation was usually
only seen at the height of economic booms and in wartime.
In the U.S., deflation is still only a hypothetical possibility, but
in Japan it is a painful reality. Japan's stock and property bubbles
deflated rapidly in the early 1990s and a series of short-lived
upswings were each soon ended by a new downturn. In this weak
environment, inflation gradually dropped to zero and then deflation
set in, starting in 1995. As of the end of 2004 Japan's price level
has fallen a cumulative 10%.
A world of very low inflation, and potentially deflation, makes the
current house price bubbles more dangerous than in the past and, from
an investor and homeowner point of view, means that houses are a more
risky investment. After past price bubbles, house price adjustments
were limited in nominal terms by the cushion of high underlying
inflation. Indeed in the United States, the nationwide price index
has never fallen in nominal terms. In fact, there was a 10%
adjustment in real prices in the 1990s, but it was hidden by the high
consumer price inflation of the time. In some regions, the real price
adjustment was greater and so nominal prices fell too. For example,
Californian home prices fell 10% in nominal terms in the early 1990s,
with a 24% decline in real terms.
How much effect would a fall in house prices have on the economy? The
bursting of the 1990s stock market bubble wiped about $5 trillion off
U.S. household wealth. It would take a 33% fall in home prices to
have the same impact. A decline of this magnitude cannot be ruled out
if valuation ratios for housing, such as the house price-earnings
ratio or the house price-rents ratio returned to past cyclical lows,
but it would only be likely in the context of a serious recession and
a new rise in unemployment. However, wealth effects from declining
house prices are usually found to be more virulent than those from
falling stock markets, so a fall of "only" 10-20% in house prices
could present Mr. Greenspan, or his successor, with a similar
headache to the aftermath of the stock crash.
But a housing crash would have other effects too. In past housing
downturns residential investment fell sharply, by 40% in 1980-82 and
by 24% in 1988-91. This is reflected in the monthly housing starts
data, which typically halve during recessions. But starts only ticked
down briefly during the 2001 recession and have since risen close to
past peaks. Residential investment accounts for about 5% of GDP, so a
severe house-building recession would be enough to cut GDP by 1-2% on
its own. Housing Bust: Consumer Price Inflation
How likely is a U.S. housing bust? The economy enters 2005 with
considerable momentum and with interest rates still low so it seems
likely that house prices will continue to rise for a while, inflating
the bubble further. Good news on the economic front will support
house prices while rising mortgage rates (likely as bond yields move
up) will threaten them. The outcome of these opposing forces will
depend partly on how much mortgage rates do in fact rise. Continued
good news on consumer price inflation would keep bond yields low and
make higher home prices more likely. But house prices will also
depend on whether the growing signs of a bubble mentality, now
evident in some regions, extend further. When a bubble reaches the
euphoric phase, rising interest rates may have little effect because
people are entirely focused on the prospect of quick gains.
The ideal outcome from here would be a period where house prices were
broadly stable, allowing earnings and rents to catch up and
valuations to moderate. A small fall in the market of 5-10% would
help that process along, without causing too much hardship, though a
nationwide 5-10% fall would almost certainly imply falls of 10-20% in
parts of California and New England and other particularly
high-priced areas. The most dangerous scenario is if house valuations
are still extended when the next major shock hits the U.S. economy.
Stock prices would likely be falling too, so that the economy would
face a double dose of asset prices effects adding up to a much more
lethal mixture than in the aftermath of the stock market bust.
A large correction of house prices at some point, 20% for example,
would be a painful process for homeowners as well as investors in
housing. Moreover prices would likely only recover gradually since
inflation and incomes growth would likely be very low at that point.
Hence it is probable that prices would not return to their peak
levels for 15 years or more. This might not worry some
owner-occupiers. Many will have bought before the peak of the bubble
so that, while they will see some erosion of their equity and perhaps
suffer some disappointment, they may not be losing much, except on
paper. Moreover, since mortgage rates would likely fall, people would
be able to refinance at lower rates. Housing Bust: Negative Equity
However people relying on future appreciation to help fund their
retirement could be very disappointed. Moreover some people would
find the value of their house falling below the outstanding on their
mortgage, i.e. negative equity, because of the greater decline in
nominal house prices.
For an investor in housing the scenario above would, to say the
least, be a huge disappointment, because there is no capital gain for
more than 15 years. Of course, provided he could find tenants and
provided rents did not fall, his net rental yield should be positive
so there would be some income after costs, though not much given the
low level of rental yields, especially in the more bubbly areas. It
is difficult to define exactly where the investor would end up,
because a great deal depends on how big a loan he has and what rent
he could obtain. But there is no doubt that this is what disappointed
investors call "a very long term investment", or in other words a
mistake! The choice is either sell and accept the loss or wait it
out, but then miss the opportunity to make money elsewhere.
A big adjustment like this is most likely when we see a sharp
slowdown or recession and especially if house prices continue to rise
rapidly in 2005, as seems likely unless mortgage rates rise very
rapidly. The United States avoided a major recession in 2001, with
the help of massive fiscal stimulus and rapid cuts in interest rates.
But another downturn will come one day and, if house building and
consumer spending crashes too, the recession will be more severe than
in 2001. In a low inflation world, housing bubbles are a much more
dangerous phenomenon.
Regards,
John Calverley
for The Daily Reckoning
Editor's Note: John P. Calverley is Chief Economist and Strategist at
American Express Bank in London. A regular guest on CNN and the BBC,
Mr Calverley has been analyzing and writing on economics and the
investment markets for more than 25 years.
He is also the author of "Bubbles and How to Survive Them," to order
your copy at a 15% discount to the publisher's price today - follow
this link:
"Bubbles and How to Survive Them" http://search.barnesandnoble.com/booksearch/isbnInquiry.asp?userid=pO0
DdRKANh&isbn=1857883489&itm=1 John Calverley isn't the only one concerned about the imminent danger
the housing bubble poses for the United States...Fleet Street editor,
Chris Mayer predicts that the 2005 is going to be very dangerous for
anyone involved in the real estate market...He has six more shocking
predictions for the new year that you shouldn't miss:
Seven Stunning Predictions for 2005 http://www.agora-inc.com/reports/FST/predictC06
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