This is always a fairly intensive research time of the year for me, as I begin to format my thoughts about the possible trends for the coming year. Next week, I will sit down on Thursday and Friday to write my annual forecast edition. It will be a shorter letter this week, as I husband my energy for next week's marathon.
But today we will preview one part of the puzzle that will be 2004: the housing market and its implication for interest rates.
One of the secrets of the arcane art (it is not a science!) of economic forecasting that I practice is to look at the consensus forecasts and to try and discern the reasons for the consensus. Given that most consensus thought is based upon projecting current trends or wishes into the future, the key is to discern what events might transpire which could upset current trends and thus make the consensus thinking likely to be wrong.
Last week Barron's polled the usual list of famous analysts, and asked them what they thought was in store for interest rates. The average suggested an almost 1% rise in ten year rates, which is the figure that influences mortgage rates the most. They would suggest that mortgage rates will rise to 7% or more by the end of the year.
The True Wealth Effect
I have written before of studies which show that consumer confidence and thus consumer spending is highly correlated with housing prices. The true "wealth effect" is not in stocks but in homeowner equity.
Thus, as home values continued to rise throughout the recent bear markets and recession, consumers were not as worried as in past recessions, and therefore barely skipped a debt-financed consumer spending binge. The Fed helped foster this mood by creating the climate for ever lower mortgage rates. Let us make no mistake - housing prices are linked to two key factors: demand and interest rates. Demand, it seems, is also spurred on by lower mortgage rates.
Since much of our future economic well-being is mortgaged to the housing market, it will serve us well to look at a few facts.
Let's go to the website of the National Association of Realtors to see what we can glean from existing home sales. First, we went on a buying binge as a result of the low rates of this summer. Home sales peaked at a seasonally adjusted all-time high of 6.69 million homes per year. Looking at third quarter data, it seems we were buying at a pace of 7.4 million homes per year. This is up from a pace of 6 million only a few years ago.
This has dropped in the last two reporting months, declining over 9% from September's peak and back toward the still high numbers from 2001. The average "supply" of existing homes for sale has grown from a 4.3 months to 5 months in just the last two months. But is the glass half-empty? Even dropping 9%, it was still 6.9% above last year.
Rates are roughly where they were at the beginning of the year. But the drop in the summer to 5% mortgage rates clearly spurred a huge increase in buying. The national median existing-home price was $170,900 in November, up 5.9% from November 2002 when the median price was $161,400. The median is a typical market price where half of the homes sold for more and half sold for less. That sounds good for homeowners, but Greg Weldon notes that housing prices in November declined and this marks the 4th straight month where prices did not rise and a cumulative decline over that period was nearly 6%.
Will we now return to more "normal" levels but still stay relatively high? If we do, then the seemingly ever present annual increase in housing prices should continue. But what if the slowing of demand continues? At some point, weak demand will halt the pace of increasing housing prices.
It's All in the Assumptions
Investors assumed that stocks would rise forever, and bid up the price of stocks right up until March of 2000. Once again, investors assume that stocks will rise again, as we return to the 90's. Such psychological forces are powerful. That being said, expectations of increased housing prices are even more ingrained in the national psyche.
Let's look at the home construction industry and housing starts. Again, thanks to Weldon for looking at the new home sales data. He notes that new home prices are rising significantly, up almost 10% from October to November, as builders are forced to pass through increased costs. Predictably, sales went down. They have dropped by 5% over then last two months and unsold supply is 7.4% higher than last year.
(As an aside, in researching this market, I went back and looked at new home sales for the last 35 years. The latest data I could find suggest new home sales will be in the 1.8 million range for the year. If you had made me guess, I would have bet that new home sales are at all-time highs. I would have been wrong, and not even reasonably close.
New home sales were 2.35 million in 1972, when the population was 25% less: 210 million compared to today's 280+ million.)
There are 109 million households in the US. Population is growing by less than 1%. We are building homes at a growth rate over twice that of the number of increasing households. Unless new first time buyers can be brought into the market, the home construction industry will experience a rough patch.
1940: A Nation of Renters
But not to worry. With low interest rates, more people can afford to buy homes and are doing so. Home ownership rates have increased from 64% of the nation to 68% in the last 9 years. In 1940, the rate was less than 43.6%. We were a nation of renters at the beginning of this century. Freddie Mac tells us that will grow to 68.5% by 2010.
President Bush just signed a new bill giving lower income first time buyers a gift of $5,000 to make their purchase. Freddie Mac has a wonderful chart showing home ownership rates going onward and upward. They tout their "new technology" which allows for 3% down payment programs and lower origination costs as a reason to be optimistic, as well as an aging population which will want to buy more homes.
Or maybe we should worry. What if the consensus in Barron's is right and mortgage rates climb another 1% over the year? That increases the average payment of a home and thus decreases the dollar cost of homes that families can afford. It also shuts out homebuyers at the lower end of the economic scale.
What is the tipping point? What is the point at which higher rates weaken demand enough to slow (or even drop) the average price of a home?
Higher rates are not a problem in an economy that is growing AND producing new jobs. But the US economy is simply growing. We are producing some 90,000 jobs a month, but need to be doing twice that to really lower the unemployment rate. While the jobs picture is slightly better, much of the improvement in the statistics comes from the 4,000,000+ people since March of 2001 who are not counted as unemployed because they are no longer looking for a job. Some sources suggest that counting them, plus the marginally employed, would run the rate up to a more European like rate of close to 9%.
Bill King writes "Consumers' assessment of the job market deteriorated in December. Those saying jobs are "hard to get" rose to 32.6% from 29.6%. Those claiming jobs are "plentiful" declined to 12.5% from 13.5%. Current business condition sentiment also fell."
This adds one more reason as to why I think the Fed will not raise rates until at least after the election next year. Raising rates without an expanding job market will simply put the kibosh on home values.
When Will the Fed Raise Rates?
For those who keep asking me when the Fed will raise rates, I simply respond that they will not do so until the economy is clearly producing new jobs at a sustainable pace of 150,000 or more per month for several months.
Here is the equation: a lower unemployment rate will result in higher demand for homes. Higher interest rates will decrease demand for homes. A sufficiently decreased demand for homes will lower home prices. Lower home prices are the one thing that consumers will not tolerate. Lower home prices will result in lower consumer spending. Lower consumer spending will set the stage for a recession.
The Consensus is Wrong
The Fed understands this, even if the economists polled in Barron's do not. Thus, arriving back at the beginning, the Fed will not raise rates until the unemployment picture improves significantly.
But John, you old worry wart, aren't we seeing a better jobs market? The answer is yes, but I said significantly better, not just marginally.
In November, according to the Consumer Confidence Survey of the Conference Board, 2% of US households expected to buy a home in the next 6 months. Last week, that number dropped to 1.4%. That does not equate to a housing market of some 8 million new and used homes being sold in one year.
That is not as bad as it might sound, as many of us do not know we are going to change jobs or be forced to move within the next six months. We are a transient nation. How many of us have known six months in advance we were going to change jobs and move? But the one month drop-off is still disconcerting. Evidently, a lot of potential homebuyers decided to take advantage of the lower rates and stepped up their time frame. We have "bought forward."
Further, if only 1.4% are expecting to buy, that also means there will be fewer sellers. Lower existing home sales is not bad thing in terms of housing prices, as long as supply and demand are balanced with fewer people wanting to sell (unless you are in the real estate business).
Taken all together, if the recent softening data is telling us anything, it suggest that it will take an improving unemployment picture simply to MAINTAIN housing demand, let alone increase it enough to let the Fed feel comfortable about raising rates.
Next week, we will examine how much of the recovery can be laid to the stimulus from tax cuts and mortgage refinancing. But since we are on the subject of housing, let's look at the mortgage application data. Weldon notes in last week's Money Monitor:
"Meanwhile, the already severe, and now worsening, EROSION in the Fixed- Rate sector continues unabated:
"Fixed-Rate Mortgage Applications ... down (-) 7.5% for the week, putting it down (-) 25.4% over the last four weeks, and DOWN by a STEEPLY negative (-) 45.6% yr-yr.
"Refinance Index ... reading of 1908.3 in latest reporting week, was down (-) 7.9% for the week, but more importantly, represented the SECOND LOWEST reading of the YEAR, second only to the lowest reading posted just two weeks ago ... while the Applications for Refinancing have PLUNGED by (-) 53.5% on a year-year basis.
"Indeed, the Refi-Index has now posted two weeks in the last three, BELOW the 2,000 level. Compare that, with this year's PEAK reading, posted at 9,977.8 during the last week of May, during a string of three consecutive weeks ABOVE 9,000 !!!"
This is not to say the housing sector is getting ready to fall off a cliff. It is not. It will slow down from the torrid pace of 2003, but is should remain ok for 2004, as the point is that the Fed is going to do everything in its power to keep rates low, and I think rates are going to stay low a lot longer than the conventional wisdom thinks. That should help at least maintain housing prices, if not continue to give them their usual upward growth.
I will talk more on rates next week, as they are one of the keys to 2004, but for now, let's end this letter a little earlier than normal, with a recommendation for starting off your New Year.
Early To Rise
I will give you one of my little secrets: my friend Mark Ford writes the excellent (and free) daily e-letter, Early to Rise. Spending a few minutes reading it each day is like having my own personal business coach. It focuses on business and marketing issues as well as personal goal setting strategies, etc. ETR is one of my must reads. You can get it at http://www.earlytorise.com/SuccessStrategies.htm. Mark is one of the best marketing minds in the world.
San Francisco, LA, and Miami
This next year looks like it could be one of the best in terms of my personal business. While 2003 was a good year, it was the most stressful year of my life. I am glad to see 2004. It also is shaping up to be one of the busiest travel years of my life, which means a lot of planes, but also the opportunity to see more of my clients and friends. I have put off so much in an effort to finish the book that I will need to play "catch up." After some business meetings in Santa Barbara, I will be in San Francisco on January 12 and 13. I will be traveling with Matt Osborne, the Director of Research for Altegris Investments. We will be looking at several hedge funds, but I will have some time to meet with current and potential clients.
I will be in Pasadena and Long Beach on the 18th and 19th to help celebrate Rob Arnott's growth from zip to $1 billion under management in less than two years. He runs a fund for Pimco that has been blazing and he deserves the success. I will have some time to meet with a few people.
I will be in Miami from February 7-11, attending the Managed Funds Association Conference with Jon Sundt and the team from Altegris. We will have plenty of time to meet with people. The week before, I will also be in Calgary speaking at private investment conference for the energy investment banking firm of Peters and Company at Lake Louise, and I will be taking my bride to get away for a few days.
It has been a great holiday season with lots of kids and friends, and this weekend is the last of period, as I get back into full swing on Monday, after my annual doctor's appointment, where he will hopefully once again tell me all my aches and pains are simply getting older and that I am in great shape.
Here is wishing you a happy and prosperous New Year.
Your expecting our best year ever analyst,