As I have written about and documented on many occasions, the economic health of the US consumer is hinged upon the housing market and housing values more than any other single factor. Since the entire economy, not to mention the world economy, is heavily leveraged to a healthy US consumer, the question of whether or not there is a bubble in the housing market is of paramount importance. Today, we begin a series on housing. I have found the research to be fascinating and often surprising and contradictory. I trust you will find it useful, and it is almost guaranteed to be debated, as I will depart from the Conventional Wisdom of both housing bull and bears.

Thoughts on the Money Supply

But first, I want to address the recent dramatic rise and now slowing of the growth in the money supply as measured by M-2 and M-3. Many commentators breathlessly see alternatively either doom or a new bull market based upon these monetary measures, or the sinister hand of the Federal Reserve manipulating the markets.

I think the Fed is only secondarily responsible (at most) for the recent moves in the money supply. Remember last week I talked about how the carry trade is unwinding? Greenspan gave his warning in March and the funds and corporations began to act. We are watching hedge funds and other institutions who were involved in the carry trade have a particularly rough time (on average), and in general hedge funds involved in the carry trade have lost money for the last two months (and so far this month), after a very good run over the last few years.

The Fed has ways to influence (much less than you might think) the money supply (M-2 and M-3), but not actually control it. There is no man behind the curtain pulling levers. Or, if he is pulling, I am not sure they are connected to anything.

I think the rapid growth in the money supply is yet more evidence of hedge funds and corporations unwinding their positions and going to cash. To the extent that the markets heeded Greenspan's warning, the Fed "influenced" the money supply. But it was nothing they have done directly. While the rapid rise in the money supply was funds and corporations repatriating cash from abroad and from the carry trade, the recent slowdown is a result of the funds and corporations deploying that cash they raised over the last few months into other investments.

This is corroborated by the movement in the Treasury bond markets, as rates went much higher (hedge funds and corporations were selling in size and in concert) and then as the selling is drying up, rates came back down.

Maybe I am like the man who fell off the Empire State Building, who noted as he passed the 48 the floor that "So far, so good." But I think that the carry trade seems to be unwinding far more smoothly than I would have imagined last year as we saw the trade being "put on." Frankly, I expected one or two hedge fund blow-ups (not a large percentage out of 8,000 funds, by the way), but I have not heard of any. They may still be out there, but for now it is just the usual expected losses which always accompany the end of a trend.

That is also why I now think that a raise of 25 basis points on the 30th is locked in. If the Fed raised 50 bips or did nothing, the markets would "throw up." "Measured" is the watchword of the Fed this week. They are telegraphing their moves as much as they can. Any manager who suffers a "surprise" loss because rates are raised 25 basis points should be fired.

The Daily Reckoning

Before we jump into the housing question, permit me a brief, yet hopefully educational, commercial. Fellow author and writer Addison Wiggin (co-author with Bill Bonner of Financial Reckoning Day) gave me a very kind review this week in the Daily Reckoning. Let me quote a few lines, not just because they are laudatory, but because I think they are instructive.

"Investors, Mauldin suggests, continually make [the] same mistake, substituting familiarity for value-based research and reason, basing their investments and their future on false confidence that, in the end, leads to disaster... Just because we know a lot about an investment does not mean it is a good one.

"But where then, does Mr. Mauldin find the right kind of confidence? In a true sense, that search is the unstated theme of his book... and it comes from several sources.

"First, it is the steady march of history. Mauldin sees the stock market, currencies, commodities, bonds, interest rates - in short, everything - as subject to historical, economic and fundamental forces. Finding these forces and investing with the trend - rather than against it - is the key to confidence. Where some might see the continued decline of the dollar as a reason to despair, John simply sees another trend from which to profit. If the economy grows slower than in the past - something Daily Reckoning readers will recognize as Mauldin's 'Muddle Through Economy' - again it is not a problem, but an opportunity.

"When the Fed wants to manipulate interest rates - they may theoretically be wrong - but astute investors recognize it as a gift of potential personal profit. Every chapter of Mauldin's book is grounded in history... yet he steps out on occasion and deigns to predict the future.

"If you're a regular reader of the Daily Reckoning, you know Mauldin believes that value is the driver of market cycles. In Bull's Eye Investing, he offers numerous ways that small investors - which he demonstrates have an inherent advantage over institutions in today's market - can invest with confidence in today's market. His chapters on value investing may be considered as essential reading for the individual investor. Mauldin's data mining on 'behavioral investing' is worth an entire book of its own.

"Bull's Eye Investing is a must-read roadmap if you want to avoid the pitfalls of the modern investing landscape..."

The book is again on this month's New York Times Business Best-seller list. You can find it at your local bookstores, or buy it at discount at http://www.amazon.com/bullseye. And now on to housing.

What Housing Market?

Over the years, I have had more questions from readers on my views on housing than on any other topic (with the possible exception of gold). These questions are almost invariably impossible to answer, as I know nothing about the real estate market in Des Moines or White Plains or Portland.

Whether to buy or sell a house is an intensely personal as well as an intensely regional (if note very local) exercise. There are just too many factors in the equation. What I have been able to do on occasion is to cause the reader to ask a few questions in order to help him solve his own equation.

Are we in a bubble? Should I sell and rent? Should I buy today or wait until next year? And, if so, at what interest rates? Will I be able to use the value in my home for retirement? In this series on housing, we are going to look at these questions and more.

The answers will not be what you expect. There may indeed be "bubbles" in housing values, but not always where you suspect. Price is not always the determining factor in housing bubbles. Many are moaning about the fact that ARMs (adjustable rate mortgages) are on a dramatic rise, portending doom in our future as rates rise. Well, some studies and line of thought suggest maybe not. They may in fact be a very smart thing to do. Average housing sizes have doubled over the years. Should we look at historical homes prices on a per square foot comparison? We demand more quality in our homes. What effect does this have on housing prices?

As I mentioned, to analyze your own housing buy or sell equation is intensely personal. My premise is that the equation is based on a number of variables, both personal and economic. The values for the variables change from person to person and market to market. For instance, higher rates may mean lower prices in some markets and not in others. What we are going to do is look at a number of studies, statistics and reports and hopefully a few new insights along the way to give you the knowledge you need to do your own equation. My aim is to help you think outside of the box.

Bubble? Please Give Me a Housing Bubble

Let's first look at the actual statistics for housing prices. What we find is that a national number is meaningless to an individual.

For instance, average U.S. home prices increased 7.71% from the first quarter of 2003 through the first quarter of 2004. Appreciation for the most recent quarter was 0.96% or an annualized rate of 3.84. These and the next few statistics are from the friendly folks at the Office of Federal Housing Enterprise Oversight (OFHEO), which uses the databases of Freddie Mac and Fannie Mae to create their Housing Price Index. This index tracks average house price changes in repeat sales or refinancings of the same single-family properties.

Housing far out-paced the price for goods and services in the CPI, as goods and services only grew at 1.59%.

But what does 7.71% mean? If you are in Rhode Island or Texas, it means nothing. Rhode Islanders saw their housing prices jump 14.8%. Texas saw a decidedly modest 2.34%.

Home prices may be softening in some areas. There are 220 Metropolitan Statistical Areas (MSAs) in the US. Almost 20%, or 39 of those MSAs, saw home values drop on the first quarter of 2004, compared with only 3 in the fourth quarter and 4 in the second quarter of 2003.

OFHEO Chief Economist Patrick Lawler notes, "Last year's rise in borrowing rates may have stimulated fears of further rate increases, causing some prospective purchasers to move more quickly to buy than they might have otherwise last Fall. That sense of urgency apparently diminished last quarter after rates stabilized. It will be interesting to see what the effects of more recent interest rate increases are in the future."

Interesting indeed.

Let's see if we can put housing prices in some inflation-adjusted perspective. If you bought a $100,000 home in 1980, if it merely kept up with inflation, the home would sell for approximately $240,000 today. The average US home bought in 1980 now sells for $309,000. Thus, roughly 70% of the average rise in housing values is simply from inflation.

However, if you lived in New York, your $100,000 bungalow is now $499,000. Rhode Island is not far behind at $461,000. California home values have risen to $414,000, although in such a vast state, there is quite a difference in price increase in San Diego beach front and the desert, I am sure.

But the leader in terms of rising home values is Massachusetts. Your $100,000 1980 cottage is now a staggering $616,000. I find 8 states which have seen their values increase at more than double the rate of inflation. Massachusetts is almost 3 times the rate of inflation.

But it is not all sweetness and wealth. If you lived in Texas, as I do, a small bubble might be a thing to be desired. Housing values in Texas have not kept pace with inflation. Our $100,000 home is now only $188,000. Of, course, we can look to the north to Oklahoma, the state with the smallest rise in the US, whose homes have risen to only $174,000. That means their home values only rose about half the rate of inflation. I count 15 states which have seen home values rise less than inflation over the past 24 years.

But the bubble, if there is one, is something of recent vintage. What about the past five years? Utah has seen home values rise less than 10% in the last five years. While then average home has risen 41% in the US in the past five years, 23 states have seen rises of less than 25%.

Of the 220 SMAs, over the last year the top 20 come from California (10), Florida (6) New England (3) and (oddly) Las Vegas. Among the bottom 20, I find my own region of Fort Worth-Arlington (Texas) at #213 and Austin coming in dead last.

The OFHEO study looks at price rises state by state since 1985. If you bought a home almost anywhere in New England, unless it was over some environmental disaster, it has been a no-brainer for the last 24 years. You saw your equity do nothing but soar, assuming you did not borrow against your home. Some place called Barnstable, Massachusetts has seen their values rise 100% in the last five years alone.

But if you bought a home in 1985 in Texas, you had to wait for 12 years to see your home rise a mere 10% in value. If you live in Texas or Utah or any of scores of areas in the United States, you simply do not understand home prices in DC or New York or California. Far from being a bubble, much of US home values have not even kept up with inflation.

(I remember recently showing my friend, Constantin Felder from Geneva, Switzerland around my home town. He would look at some of the rather large homes in the area and marvel at the low prices. A $400,000 home here would cost millions in Geneva, or Boston or La Jolla, for that matter.)

You can read the 56 page study and tables for yourself at http://www.ofheo.gov/media/pdf/1q04hpi.pdf. It is interesting to compare the various parts of the country and play "what if." As in, what if I had taken that job in DC 25 years ago?

Housing and "Intrinsic Value"

There does not have to be a bubble for prices to fall, and fall dramatically. In a theme we are going to return to again and again in this series, there is no such thing as "intrinsic value" in a home. It is a function of several factors, including demand and economic conditions.

Home values in Houston, Texas were already relatively cheap in the 80's when first oil prices and then the savings and loan banks collapsed. Lending for everything dried up as the as the banking system, based on oil and land values, simply imploded.

Already inexpensive homes became cheaper as employment in Houston dropped dramatically. Homes were selling at auction for one or two year's rental value. People literally bought them with credit cards. As the government flooded the markets with re-possessed homes, values dropped even more. People could buy homes in some areas for much less than replacement costs.

Forget about equity back then. In 1991, I wrote a large check just to get someone to buy my home which I had owned for 8 years. That was not untypical in Texas. Of course, I turned around and bought a home from the government agency overseeing the bankruptcy of the savings and loan banks in Texas, for about 35% of what it listed for less than three years earlier, and about half the value of the actual loan which had been made by the bank for the home.

You could not have built that home for anywhere close to what I paid for it. Over the next ten years, it proved to be a reasonable purchase. However, the 50% rise in price did not come close to what we see in other parts of the country.

The point? Home prices are tied to local economic events. Please note that ten of the top 20 MSAs for the last year were in California. But that is small comfort if you lived in San Jose, where your home prices have dropped over the past few years as Silicon Valley is still reeling from the bursting of the tech bubble.

If a factory closes and 10% of a region is out of a job, sooner or later housing values take a hit, unless the town fathers can attract another employer. It does not make a difference whether housing values had been rising 10% a year for ten years, or were already below replacement costs. The economic factors of local employment drive demand and thus housing prices. (Other economic factors, which we will review later, will also affect demand.)

Still, over time, home ownership is a compelling investment. Let's take the (almost) worst case over the past 24 years, buying a home in Texas. In 1980, you buy a home for $100,000, with 20% down. You were paying 12.5% in interest.

Over the next 24 years, you refinanced several times as interest rates and your payments went down. If you have not already paid off your mortgage by now, you are close to it. Your home is now worth $188,000. You have seen your investment of $20,000 grow 9 times, plus you have deducted the interest rate costs from your taxes. Not a bad return. Better than the stock market, actually. And you had a roof over your head, which an index fund does not provide.

But what if you bought an average home in Massachusetts? Your $20,000 is now $616,000! Are you smart or what? Simply for putting up with Ted Kennedy and the Red Sox (hey, this could be the year!), you are one of the richest guys in the country.

If you were lucky and had some coastal property or other prime location, then your wealth is off the charts, assuming you held through the years. Of course, if you bought a home in Massachusetts in 1989, it was 1997 before you saw a profit. Tough sledding in those years.

In fact, if you look at the tables in the report, you find that every state had rather lengthy tough periods in the 80's and 90's in which home values fell or were at best stagnant. That includes California, which had some very flat or negative years. The experience of the last five years which have seen such a dramatic rise in price in many areas has happened before, but it is almost always followed by a slowdown in price, which happen for a variety of local reasons, which we will look into in the coming weeks.

Let's end with story from one of my favorite perma-bear writers, Gary North. I love his wit and fluid style. And this section is typical.

"I watched 'Sunday Morning' a few weeks ago. They ran a segment on the Los Angeles residential real estate market, which is blisteringly hot. Some couple was hoping to buy a home for $600,000. They had been locked out by other buyers recently. Their offer of $500,000 had not been sufficient. The real estate sales lady commented that houses that were $600,000 last year are selling for $1.2 million this year. Anyone who didn't get in last year is locked out today.

"I shuddered. If they could have heard me, I would have yelled at that 30-something couple: 'Run for your lives! Rent. Move to Wisconsin. Anything. Don't sign that contract!' Of course, I would have yelled to the sellers, 'Way to go! You've got 'em. Take the money and run. Move.'

"Think of a couple that owe, say, $200,000 on a $1.2 million home. If they moved out and rented for a few months, they would establish their house as an investment property. Then they could sell it, pay off the $200,000, move to Northwest Arkansas, invest $1,000,000 by buying ten homes and renting them for $800 to $1,000 a month. They would enjoy income of $8,000 to $10,000 a month, and they would see their investment double in the next ten years.

"They could even hire a local rental agency to handle it for 10% of rent, and they could stay in L.A. and rent for $2,000 a month, pocketing maybe $4,000 after taxes.

Will they do this? Of course not. They will buy a $1.4 million home.

"A housing mania makes fools of buyers and sellers. Buyers don't know how to say no and rent in peace (RIP). Sellers never know when to quit. Their ship has come in, and they're at the bus station."

Is that $1.2 million home necessarily a bad investment for that couple? Maybe and maybe not. If they expect to flip it in 2-3 years, they are taking a significant risk. They are buying after a large run-up in home values. Looking through the OFHEO tables suggest that run-ups are followed by softer periods.

But if it is their dream home - the place where they want to live for the next 20 years - and if they have the ability to make the payments in that time, then inflation and the long-term affect of paying down the mortgage (especially if they lock in historically low long-term rates) should overcome the ups and downs, assuming they do not have to sell during the next recession. If California is where they want to live, if it is where they make their living, then housing is part of the cost of doing business in California. (Not to mention high state income taxes and other government nonsense.)

Housing is not simply an investment decision. There are emotional and psychological parts of the equation that must be factored in.

My business partner, Jon Sundt of Altegris Investments, has a truly magnificent home overlooking Black's Beach in La Jolla, California. There is no good reason he could not move his business to Texas, buy a similarly truly magnificent home and pocket more than few million. His business overhead would drop dramatically. He would get an immediate 10% raise in income as there is no state income tax. I have pointed this out to him on a few occasions. But it is not just a business, dollars and sense, equation.

"Where," he asks, "do I go to surf? Where are the sunsets on the beach in Fort Worth? How do I get my wife to come to Texas in 100 degree weather in August? Or freezing in January?"

Jon is married to the beach, the weather and the lifestyle in coastal southern California. He and millions of people like him. Over the long term, that is good for property values there. It is no guarantee of anything, as over the next 20-30 years, values will rise and fall, as they always do. But if you are not selling, the price of your home is simply a number. Perhaps it makes you feel good, or perhaps not.

If you did not have to sell your home in Houston in the 80's, made your payments and simply kept on going on, you saw your home values come back and your equity increase. It took some time. If you needed to sell at the wrong time, you got hosed big-time (note to non-Texans: that is slang for beaten up).

What have we learned so far? Parts of the housing equation are the desirability of your local market, the length of time you intend to live in your home and your own ability to stay the course, local economic conditions and your own psychology.

Next week, we look at a Harvard study which says housing is not over-priced. Then we find some apple and oranges flaws in their arguments. We delve more into the psychology of housing and how it affects the national consumer sentiment, and a few other thoughts. I should note I now lease a home, but plan to buy, and we will look at the personal equation from my own decision making process.

Howard Ruff Writes Again

Before I sign off and go and see my twins who have finally come home from college, I want to mention a rather special book by one of the grand old names (and a good friend) in the investment writing business, Howard Ruff.

For younger readers, Howard built the first large investment newsletter (The Ruff Times) in the country, with hundreds of thousands of subscribers over the years. His book in the late 70's, How to Survive and Prosper in the Coming Bad Years, sold almost 3,000,000 copies. He was a political mover and shaker, meeting presidents and politicians and kings. He roamed the world and was a magnet for crowds wherever he went. He had his own syndicated TV and radio shows, and appeared on Oprah and every big TV show there was at the time. He could move stocks on a mention. He was a certifiable Big Deal.

He also made and lost two fortunes. And therein lies the tale worth the telling.

His new book, "Safely Prosperous or Really Rich: Choosing Your Personal Financial Heaven" is worth reading on two levels. First, Howard shows that there are really two ways to retirement prosperity in the world. You can either live modestly and save and watch your nest egg grow over time. Or, you can take certain risks and start your own business. It's not how much money the really rich have or how smart they are, it's their attitude toward risk and fear, their understanding of when to break the rules that the Safely Prosperous follow, and their knowledge of a few simple capitalistic principles that allows them to accumulate serious wealth. It is full of lots of solid wisdom that Howard has gathered over the years.

Howard is a great writer and the book is an easy, even fun, read. Old fans of his will enjoy their reunion and he will gather new ones, I am sure.

But the book is more than a "how to get rich" book. It is Howard's tale of his personal business rise and fall and rise and fall, and he does it with no holds barred. It is emotionally jarring in its brutal honesty. We all like to brag about our success. Howard has had more than a few. But it is his mistakes that he holds up to inspection that make the book special, at least to me. It is a cautionary tale full of wisdom that only comes from a few bruises and broken bones. If you are in a business, there are a few chapters that are simply must reading. I am serious. Every business owner, and especially those in the investment publishing and writing world, should read them and weep and rejoice along with Howard and learn.

Howard at 70 is one of the most optimistic guys I know. He fought cancer had survived. He faced crisis on more than one occasion and kept his wits and his optimism about him. With something like 18 kids and 60 or so grand-kids, he stays young. He is still writing the Ruff Times, and plans to make it a major letter once again.

The book is a mere $16.97 at Amazon.com. I just looked and noticed (entirely coincidentally, I assure you) that his book on Amazon is linked with mine and you can buy both of them for $34. http://www.amazon.com/exec/obidos/ASIN/0471652830/frontlinethou-20

Father's Day

I am a piker compared to Ruff. I merely have seven kids and no grand-kids. But Father's Day is still a special time. Daughter #1 is in Poland, but sent me an email which more than warmed this Dad's heart. I still read it when I need a psychological boost. The rest of the gang will be there Sunday, with lots of noise and shouting and fighting and fun. I will pick up the check for lunch, but it is worth every penny.

There are those who think someone with seven kids must be crazy. How can I afford it? With three (and hopefully four, if she will go back) kids currently in college, I often ask the same question. But the answer comes to me when I go back and look at a website my kids gave to me a few years ago, http://www.bestdaddyintheuniverse.com. Just as some pay the extra costs for living in California, the "extra" costs for my kids seems like a good investment. And the dividends, like that letter, or a sunset on the beach, come in different ways, but they are valuable, if not priceless, all the same.

To all Father's everywhere, I wish you the joy I have.

Your missing his own less-than-sainted Dad analyst,