May 11, 2008

I was out dining on Friday night. The restaurant was located in an upper middle class neighborhood shopping center in Walnut Creek, a suburb about 20 miles east of San Francisco. I didn't remember having trouble finding parking space before. But, the parking lot was packed on Friday and so was the restaurant. Most of the cars on the lot were either SUV's or trucks; rising gas price appeared to have no effect whatsoever. The place was hustling and bustling. Inside the restaurant, waiting list's expanding, drinks were flowing, and customers were smiling. There's hardly any sign of recession, except when I looked across the street.

Standing in the dark diagonally across the street was a large backlit sign that used to score a national title insurance company's name; it's now covered up with tarp. Just a few feet away from the empty office space, there's another blank outdoor signage that used to display the name of a powerhouse real estate brokerage, which was part of "the world's largest real estate network". There's hardly any sign of life.

The contrast between the gloomy real estate industry and the booming consumer spending makes me wonder, in the grand scheme of things, whether the deflationary effect of the housing market meltdown might be a much needed relief for consumers. What happened in Walnut Creek is certainly not an esoteric phenomenon. Consumers are still out spending and gas guzzlers are still roaming the earth. Businesses, too, could use a little deflation. JetBlue founder, for an instance, had recently expressed his desire for the airline industry to get a much needed deflationary relief. With rising commodity prices, an expanding housing market would've been too much of a strain on the economy.

While the demise of the housing market makes a strong case for everything that's gone wrong in the economy nowadays, a strong argument could also be made for everything that has NOT gone wrong yet.

For one thing, GDP hasn't had two consecutive quarters of negative growth, which is considered the benchmark for recession by many, and consumers certainly haven't stop spending yet. They're not just out shopping and dining. Attendance at sporting events had been breaking one new record after another. The Major League Baseball's attendance, for an example, nearly reached 80 million in 2007. That's 4 consecutive years of record breaking attendance. And, 2008 is estimated to be yet another record year for baseball attendance. Unlike the previous recession or strike-shortened years (see Chart 1 below), recent attendance records display no signs of slowdown whatsoever.

Chart 1

Wholesalers Inventories to Sales Ratio also displays no sign of a stalling economy or inventory buildup. Except for a bump in the road during the 2004-2006 Fed rate hike cycle, this ratio has actually been in a long-term downtrend since last recession and the Fed's rate hike cycle that ended in 2001 (see Chart 2 below).

Chart 2

It is then quite baffling to hear that the economy's already in a recession when consumers keep buying and businesses keep selling. Perhaps media's selling the recession story so well that 9 of 10 respondents in April's Reuters/University of Michigan consumer sentiment survey think the economy is in recession. I'm not a fan of conspiracy theories, but peddling the recession story certainly helped the Fed's case of dropping interest rates. Now the Dollar had fallen so much and commodities had risen so fast that we're starting to hear recession's over before we had even entered into one.

The truth is usually somewhere in between. The deflated housing market and all its related syndrome had indeed caused the U.S. economy to slow down. But, so long as the "damage" is contained to limited segments of the economy, and the housing market deterioration stops short of bringing down the aggregate level of demand, the neutralizing effect of the housing market slump may turn out to be quite helpful. Some housing indices did begin to point to an end of a downward spiral while the aggregate consumer demand remains resilient. This is what had turned Wall Street on recently. And, the stock market responded accordingly as though the worst was indeed over.

One of several housing indices that displays pattern of a possible housing market bottom is the homebuilders Housing Market Index by the NAHB (National Association of Home Builders) and Wells Fargo. This index had ticked up to 20 in February, from the record low of 18 in December 2007, and stayed at 20 for 3 consecutive months (see Chart 3 below). Since it appeared to have stopped falling, a rebound from this level, as it did during 1990-1991 recession, seems to be widely anticipated.

Chart 3

Another trace of the worst is over can be found in the National Association of Realtors existing home sales data. The existing homes Sale-to-Inventory Ratio (STIR) had been hovering around 10%, its lowest level, since last June (see Chart 4 below). While it's mathematically possible for this ratio to drop to zero, it's physically improbable to have no sales at all in the real world. And, the ratio can not be negative either. Therefore, the stagnation of the STIR can also be construed as the market bottom for existing homes.

Chart 4

However, as much as these indices have fallen to levels indicative of a housing market bottom, it's quite peculiar to note that buying activities are still at a relatively high level equivalent of the final stages of recent housing market boom.

Chart 5 below shows the MBA (Mortgage Bankers Association) Purchase Loan Application Volume Index since 1998, the previous housing market bottom. Although the Purchase Loan Application Volume had dropped substantially since the peak in 2005, it's far from reaching the trough of 1998. In fact, it's currently at the same high level as 2003-2004 (red box), when the housing market was ready to give it a final thrust to the finish line. If this is all the correction there is, then the housing market bubble either never existed or never burst.

Since empirical evidence had verified that housing bubble did come about, then it's most likely that this bubble had never ruptured. It may just take a lot longer than we thought for the housing market cycle to run its full course. Along this vane, the worst is not over yet. And, what happens next will probably not just be limited to the lower segments of the food chain.

Chart 5

Chart 6 below shows increasing number of owners of million dollar properties had begun to put their homes up for sale. Until April 2008 (black circle), the percentage of new property listings over $1.2 million in the East Bay of the San Francisco Bay Area had been in a long-term decline since 2005. This is the segment of the real estate market that hadn't been affected much by the subprime turmoil. They too have now come to the table.

Chart 6

By all means, market corrections don't run straight to the bottom. It's not unusual for the market to bounce back after periods of decline. The above mentioned housing market indices as well as recent bullish stock market action seem to reflect this happenstance.

Besides speculators, the core driving force behind housing market's run-up from 1988 to 2005 was the move-up buyers, who had sold their existing homes during that time and moved into either new constructions or better and bigger homes. This was the force that had kept the source of funds from their equities flowing, the inventory churning, and the market booming. Today, the overwhelming number of short-sale and REO (bank owned) properties on the market that comprise of up to 50% of listing inventories in some areas have put so much downward pressure on both the price and the selling conditions that, barring desperations, the real homeowners have perhaps all but given up on putting their homes up for sale.

The absence of this driving force almost guarantees further housing market decline. It's quite likely that the worst had only just begun.