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Henry To

Henry To

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is…

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An Update on the U.S. Housing Bubble

Dear Subscribers and Readers,

Please note that we switched from a neutral position to a 100% long position in our DJIA Timing System on the morning of May 5th at DJIA 10,395. For now, we will continue to hold.

The purpose of this commentary is to provide a short, but insightful update on what I argue is the U.S. Housing Bubble. Readers should know that I have been arguing for the existence of such a bubble in recent months - both in our commentaries and in our discussion forum. Of course, just as with the stock market in late 1999 and early 2000 (the bubble was mostly focused on tech and telecom stocks while value and utility stocks plunged) one cannot really make the case for a nationwide housing bubble. However, if one looks at certain regions or states in this country, one invariably will find a huge divergence in housing prices (from the national median home sales price) in states like Arizona, California, Florida, Nevada, and New York State.

A big part of my argument for a housing bubble in the United States today stems from the fact that we are in fact experiencing such a divergence. A general rise that involves most of the country's home sales prices is relatively healthy. But just as the NYSE A/D line topped out in April 1998 and continued to decline throughout 1999 and early 2000, we are currently only seeing this huge appreciation in housing prices in some areas of the country. Anybody remember that large cap growth was all the rage in the late 1990s? Similarly, can states such as California, Florida, Nevada, and New York be treated today as "large cap growth states?" You be the judge - but following is a chart (from the first quarter of 1976 to the fourth quarter of 2004) showing the annualized appreciation in general housing prices in the states of Arizona, California, Florida, Nevada, and New York - compared with the annualized appreciation in general housing prices of the entire nation:

Before I go on, I want to thank a former co-worker of mine, Mr. David Michels, for sending me this data (you can also obtain this data by going to the OFHEO website and download the OFHEO House Price Index for individual states). (Editor's note: David is currently attending business school at the University of Chicago and is planning to come back to Houston for a stint in investment banking once he is done. David and I used to work together at an energy consulting firm here in Houston, Texas).

As one can see, the appreciation housing prices in these five states are experiencing a significant divergence from the appreciation of national housing prices. Of course, there have been many such divergences and appreciation in housing prices in the past (look at New York during the 1980s and California during the late 1980s), and all of them have ultimately deflated. I don't think this time will be any different. Moreover, please keep in mind that these are nominal increases. Therefore, the latest appreciation in housing prices in these five states - in light of the lowest inflation of consumer goods we have seen in years - is definitely an outlier and will be corrected. The 2005 1st quarter data will be updated today - I will go ahead and update this chart for you in this weekend's commentary.

Recently, many commentators have tried to "explain" the housing bubble away by pointing out that the appreciation in the national median home sales price has been pretty subdued. In fact, if one compares the appreciation in the national median home sales price to, say, the Dow Jones Industrial Average over the last 30 years, then one can even argue that housing prices are relatively undervalued on a historical basis:

Sounds convincing? Maybe, but I believe this analysis is inherently flawed. Just as I explained in a previous point, we are experiencing a significant divergence housing prices in parts of the housing market in the U.S., and so looking at median sales prices on a national level is probably not a sound analysis. Moreover, the fact that we are experiencing such a divergence tells me that this latest upsurge in prices in states like Arizona, California, Florida, Nevada, and New York is definitely not healthy. Secondly, let me ask my readers this question: What do the major stock market indices tell us? Certainly, they do not tell us what the median market cap of a Wilshire 5000 company is, right? I have not done an exhaustive study on this but if such a stock market index did exist - and if we compare the national median home sales price with such an index, then I think this ratio (national median sales price divided by median market cap of the Wilshire 5000) will be very much up there compared to where this ratio is right now.

The fact that we are not doing an "apple-to-apple" comparison in the above chart leads me to believe that is an inherently flawed analysis. I believe a much more relevant analysis would be to look at the total value of real estate held by households today compared to the value of total assets (including financial assets such as stocks and bonds) that the same households are holding. Following is a chart I have shown before in our commentaries. Not only does it show the value of real estate as a percentage of total assets held by households over the last 30 years, it also shows the quarterly appreciation (not annualized) of housing prices as measured by the OFHEO House Price Index:

As indicated in the above chart, the percentage of total household assets that are being held in real estate today is unprecedented - even more so than what was held by households in the late 1970s and early 1980s - when inflation was running rampant. So what am I saying with this chart? Either financial asset prices will surge from here (pretty unlikely) to catch up or we will see a general decline or stagnation in real estate prices in the months ahead. However, housing prices in states like Arizona, California, Florida, Nevada, and New York (where we are experiencing a huge divergence in housing prices from the national median) are going to suffer badly - and the speculators (just like the speculators in the internet and telecom stocks in the early 2000s) there will most probably be taken to the cleaners.

Okay, for a mid-week update, this is getting long enough already - so I will end this will a chart that I had promised earlier. Following is a monthly chart of the Conference Board Consumer Confidence level vs. the Dow Industrials. Like I have said many times before, this is mostly used as a contrarian and an overbought/oversold indicator:

So what is this saying now? The latest upsurge in Consumer Confidence to 102.2 (vs. expectations of only 96.0) suggests to me that consumers/investors may be getting slightly ahead of themselves in the long run. Combined with a not-so-oversold reading of 97.5 in April, I am getting increasingly worried on how far this rally can sustain itself before fizzling out again. That being said, our position still remains - continue to overweight U.S. equities - specifically, the major brand names/large cap growth stocks. We will continue to avoid commodities, financials, and to a lesser extent, homebuilding stocks.

Signing off,

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