What is the relationship between housing prices and stock market forecasting? What will happen if the housing market begins to falter? Exactly what did Greenspan say about housing at Jackson Hole? We explore these topics and a whole lot more and hopefully we can tie them all together by the end of this letter as we meditate on the potential risk of the recent housing boom.
The Problem With Forecasting
Let's start with forecasting. Every few weeks I get a wonderful letter from good friend James Montier, who is the global equity strategist of Dresdner Kleinwort Wasserstein. James is an expert on behavioral psychology and investing. This week's letter is lamenting the rather poor track record of forecasting by economists and analysts.
Let me give you a summary of the paper and a few of his graphs.
"Both an enormous amount of evidence and anecdotal experience suggests that people are very bad at forecasting. This is often because we all tend to be massively overconfident. This begs two questions, firstly why do we persist in forecasting despite the appalling track record? And, more importantly, why do investors put forecasts at the heart of the investment process?
--- "Lao Tzu, a 6th century BC poet observed, "Those who have knowledge don't predict. Those who predict don't have knowledge". Despite these age-old words of wisdom our industry seems to persist in producing and using forecasts. This is all the more puzzling given the easily available data on the appalling nature of track records in forecasting. Economists, strategists and analysts are all guilty. In general, forecasts seem to be a lagged function of actual outcomes - adaptive expectations dominate forecasts.
--- "The two most common biases are over-optimism and overconfidence. Overconfidence refers to a situation whereby people are surprised more often than they expect to be. Effectively people are generally much too sure about their ability to predict. This tendency is particularly pronounced amongst experts. That is to say, experts are more overconfident than lay people. This is consistent with the illusion of knowledge driving overconfidence.
--- "Several studies confirm professional investors to be particularly overconfident. For instance, one recent study found that 68% of analysts thought they were above average at forecasting earnings! I've found that 75% of fund managers think they are above average at their jobs.
--- "Why do we persist in forecasting given such appalling track records? There are two avenues to explore - simply put, ignorance and arrogance. Dunning and colleagues have documented that the worst performers are generally the most overconfident. They argue that such individuals suffer a double curse of being unskilled and unaware of it. Dunning et al argue that the skills needed to produce correct responses are virtually identical to those needed to self-evaluate the potential accuracy of responses. Hence the problem.
--- "Tetlock argues that experts regularly deploy five ego defense mechanisms. Experts use various combinations of these defenses to enable them to continue to forecast, despite their poor performance.
--- "Why do we persist in using forecasts in the investment process? The answer probably lies in behavior known as anchoring. That is in the face of uncertainty we will cling to any irrelevant number as support. So it is little wonder that investors cling to forecasts, despite their uselessness.
--- "So what can be done to avoid these problems? Most obviously we need to stop relying on pointless forecasts. There are plenty of investment strategies that don't need forecasts as inputs such as value strategies based on trailing earnings, or momentum strategies based on past prices. Secondly, we need to redeploy the armies of analysts. They should return to doing as their name suggests: analyzing, rather than trying to guess the unknowable!"
He gives us a number of charts showing the relationship between forecasts and what actually happened. Let's look at two of them. What I particularly want you to focus on is how the forecasts lag reality. Essentially, we clearly take the current trends and project it into the future.
And the next one is even clearer as to how we use past recent performance to project future trends.
The Nobel Prize in economics in 2002 went to a psychologist, Dr. Daniel Kahneman, who helped pioneer the field of behavioral finance. If I can crudely summarize his brilliant work, he basically shows that investors are irrational. But what gets him a Nobel is he shows that we are predictably irrational. We continue to make the same mistakes over and over.
What makes for a bubble? Why do things get so out of hand? One of the reasons is simply human behavioral psychology. The longer a trend is in place the more confident we are in our belief that it will continue. Especially if we are participating in the trend to our benefit, we find all sorts of reasons that reinforce our belief that the trend will continue.
Gary North writes in today's Reality Check: "But is it a mania? This week, I spoke with a friend who bought a 2,000 square foot house in Orange County, California, in 1999. He paid $235,000. Two years later, he sold it and moved out of state. He got $350,000 for it. His son, who remained in California but did not buy a home, tells him that it just sold for $800,000."
Let's break that down. A 30 year loan at today's jumbo rate of 5.63% will give you payments of $4,607.78 a month. You can count on taxes, insurance and other costs to be another $2,000. That's $80,000 a year before you pay electricity, water, etc. or any maintenance. If your total tax rate in California is 40%, that means you have to earn around $10,000 a month or so (even after the mortgage interest break) just to make you house payment. Using a rule of thumb that says you should not buy a house with payments that are more than 1/4 your after tax income, that means over $500,000 per year! Of course, many people are paying twice that percentage (or more!) in housing costs in order to be able to buy a home.
(As an aside, you can buy a very nice 2,000 square feet home in Texas or almost anywhere in middle America for $150,000. You can buy one with some character in a very upscale community (if you can find one that small) in the Dallas area for $250,000.)
Put simply, there are many areas of the country where even above average income earners can simply not afford to own a home. They are being forced to move further and further away from where their jobs are, which is starting to really hurt a close to $3 gas in California Who is buying these homes? And more importantly, how are they doing it?
Writing machine Robert Kiyosaki, author of the "Rich Dad/Poor Dad" series of books recently wrote (courtesy of Gary North):
Nothing Down, Interest Only
"On Friday, June 23rd 2005, I was on Your World with Neil Cavuto on the Fox Network. He asked me what I recommended when it came to investing in real estate. I replied, 'If you're new to real estate investing, this is not the time to get into the game.' Unfortunately, many people are in the market late and not only have paid too much for their homes, they are over-leveraged. (quoting from an article in The Economist) he went on to say, '42% of all first time buyers and 25% of all buyers made no down-payment on their home purchase last year.' That is what I call over-leveraged. They bought late in the cycle, probably paid too much, and have signed their lives away on the dotted line. I am concerned for these people."
I read elsewhere that in some markets as high as 40% of all loans are interest only. So we have a significant number of people who have paid top of the market prices, have no equity in their homes and are not doing anything to pay down the mortgage. They are betting the trend will continue. Even though they cannot really afford the home, they believe they will be able to sell it later for a nice profit and help them buy a home somewhere else they can afford.
These homebuyers are making the same mistake as professional stock analysts and economists: they are projecting recent past performance well into the future. It is sadly part of the human condition.
One of my favorite analysts is John Bartlett, of the National Center for Policy Analysis. He suggests that US homeowners are highly leveraged and therefore are more vulnerable to a housing price decline. Some of the points from his essay are sobering:
In the last four years, homeowners have taken $559 billion in equity out of their homes. The Federal Reserve says that 16% of that money was simply consumed (short term non-capital purchases). Cash-out refinancings have risen to 18.1% of all refinancings, up from 7.2% in 2003. According to the Federal Reserve, home equity has fallen to 56.3% of real estate, down from 75% a generation ago. More and more homeowners are buying and refinancing with unconventional loans (such as adjustable-rate and interest-only mortgages) rather than traditional fixed mortgages. Such loans have lower initial payments but will rise automatically when interest rates go higher. The Federal Reserve says that 47% of all residential mortgages by dollar volume are now non-traditional.
How did we get here? A major part of the reason is the ever lower interest rates of the last 20 years. As mortgage rates came down, housing has become more affordable. Secondly, our country is growing in population (which is a good thing), people are living longer and thus demand for housing has increased.
Demand is a big part of the equation. The Economist reports that in some areas of Germany, where population is falling, that home prices are falling as well. There are homes in rural America, where fewer and fewer young people are staying in the small towns, which have seen little price appreciation on existing homes, and in some cases significant drops.
But in general, demand has been rising as the cost of a mortgage has been dropping. This week we saw existing home sales fall and the inventory of existing homes rise close to a 4.6 month supply. That doesn't seem so bad, does it? But that is not the whole story. Existing home sales are actually going along at quite a torrid pace. There have only been two months with slightly more sales.
The inventory of homes in 2002 was 2,108,000 and sales were 5,631,000. Back then that was a 4.7 month supply. But today we find an inventory of 2,751,000, but because we are buying at such a hot pace, the monthly supply is still calculated to be almost the same. (http://www.realtor.org/Research.nsf/files/REL0507EHS.pdf/$FILE/REL0507EHS.pdf)
If sales really start to slow down, then that inventory could rise very dramatically. If a slowdown in the economy caused home sales to drop to the level of 2002, which was not a bad year for home sales, inventory could easily rise to 6 months or more very quickly.
Greenspan Gives a Very Clear Warning
Now, let's turn our attention to Jackson Hole, Wyoming, to the annual Kansas City Federal Reserve Bank meeting. (My invitation got lost in the mail again this year.)
For the last four years, Greenspan has given his clearest, easiest to understand speech for that year at Jackson Hole. This year was no exception. His speech was on the evolution of central bank policy decision making.
Let's look at five key paragraphs. (Emphasis throughout is mine.)
The first part of the speech Greenspan talked about how Federal Reserve policy has moved to a risk management philosophy. They look at a wide range of possibilities, and work to try to make sure that the worst of the outcomes do not happen. Thus, says Greenspan, even though lowering rates at the pace and extent they did in 2002-2003 might have created a problem, they felt the risk of deflation was the greater concern and did what they felt necessary to stave off any risk of deflation.
(Please note that in 2003, when I was writing Bull's Eye Investing, I wrote a chapter emphasizing this very point. I had more than a few critics who thought I was wrong in interpreting Fed policy. At least in this instance, I think this speech puts my analysis in the category of dead on target. Not that I'm sensitive or anything.)
"The structure of our economy will doubtless change in the years ahead. In particular, our analysis of economic developments almost surely will need to deal in greater detail with balance sheet considerations than was the case in the earlier decades of the postwar period. The determination of global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them. Our forecasts and hence policy are becoming increasingly driven by asset price changes."
Read that last sentence again. I have been writing for months that I think the Fed is targeting asset prices, and specifically home prices. They are worried about a bubble creating problems in the economy.
The Fed Is Targeting the Price of Your House
And now, Greenspan says above they are targeting asset prices. Can it be any clearer? You think they are worried about a stock market bubble? Commodity or gold prices? What other asset price is driving Fed policy? I think they perceive the greatest risk to be a continued housing bubble, and they are going to move to do what they can to let the air out of the bubble. Continuing:
"The steep rise in the ratio of household net worth to disposable income in the mid-1990s, after a half-century of stability, is a case in point. Although the ratio fell with the collapse of equity prices in 2000, it has rebounded noticeably over the past couple of years, reflecting the rise in the prices of equities and houses. Whether the currently elevated level of the wealth-to-income ratio will be sustained in the longer run remains to be seen. But arguably, the growing stability of the world economy over the past decade may have encouraged investors to accept increasingly lower levels of compensation for risk. They are exhibiting a seeming willingness to project stability and commit over an ever more extended time horizon.
"The lowered risk premiums--the apparent consequence of a long period of economic stability--coupled with greater productivity growth have propelled asset prices higher. The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions. The conversions have been markedly facilitated by the financial innovation that has greatly reduced the cost of such transactions.
"Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."
Again re-read the last paragraph, especially the last three sentences. Greenspan is clearly saying that you should reduce your risk in your investments and business. He is saying that you should not project the current trend into the future. There is more risk than most investors are assuming. He is warning, in as clear as possible terms, that housing prices could easily go down. And in fact, he is all but saying that he intends to help them do just that!
He, and the rest of the Federal Reserve board, seems intent upon raising rates. We have had several speeches in the past few weeks by Fed governors making that clear. This seems to me like a mindset that suggests the Fed is going to do what they have historically done in the past. They raise rates until the economy slows down or the yield curve inverts, or both!
Why would they do that? Because they think the worse risk is letting the housing bubble continue. In the 1960s, William McChesney Martin described the Fed's role as taking away the punch bowl before the party really gets going. Greenspan is taking the punch bowl away in measured steps. He is being as transparent about his intentions as a Fed Chairman can be.
He started out using the word froth a few months ago and now he characterizes the housing market as an imbalance. Quoting:
"If we can maintain an adequate degree of flexibility, some of America's economic imbalances, most notably the large current-account deficit and the housing boom, can be rectified by adjustments in prices, interest rates, and exchange rates rather than through more-wrenching changes in output, incomes, and employment."
Who will get hit first? Speculators in housing markets that have borrowed with no (or little) money down at short term interest only rates. Look around at your home town. If there are a large percentage of homes being bought as "investment" property which could not be rented out on a positive cash flow basis, you are probably in a bubble. You should carefully weigh your options.
Let me speculate, despite the fact that the first part of this letter was about the uselessness of forecasts and speculation. I think the Fed is going to increase rates until the rampant speculation (no pun intended) in the housing market goes away. They are going to raise rates until housing slows down. Of course, since 40% of new jobs in the last 4 years have come from the new housing sector, and since a great deal of the increase in new consumer spending has come from cash out financing, this is likely to slow the economy as well. They are prepared for that.
When the housing bubble starts to deflate, when the speculators have been put away, when the economy starts to slow and roll over into recession, they will once again lower rates, slowly providing a prop to the real housing market that 90% of the country participates in. That $800,000 home in Orange County? It is going to be along time before that house will sell at that price again once the Fed is finished. But most of us will do just fine. And maybe we get to re-finance our homes at an even lower rate.
What should you do if you are in a bubble area? Think about how much equity you could get for your home today. How much income will that money generate in a bond or CD? Look around at your rental market. If you can rent a comparable home to what you have today for a good deal less than what you are paying plus the income you will get from your equity, then consider selling. My bet is you will get to buy another property back in your area at a much lower price in a few years.
All housing bubbles have this in common. At first, people refuse to sell at a loss (another common psychological trait). It takes a while, but as banks start to repossess properties in your area, they will put them on the market. Prices start to drop. Then the psychology changes. The same human beings that thought that houses could only go up now think they can only go down. They start waiting. Prices go lower. Inventories build.
The Fed starts lowering rates and you will get a chance to buy a home at a lower price at interest rates lower than they are today.
By the way, I am not against buying investment real estate if you can find properties that can offer positive cash flow. Lots of people have made solid fortunes doing that. But I think in the coming slowdown/recession you are going to have better opportunities to buy investment real estate.
You have been warned.
Final thoughts: the housing bubble can go on longer than one might think, and the Fed can raise rates more than anyone now suggest. It is going to be a very interesting ride. Strap yourself into your seats. But as I will re-visit in a few weeks, I still think we are in a Muddle Through Decade.
New Orleans and Birthdays
Starting September 16, I am on the road to seven countries and about 12 cities in the following 9 weeks. I am enjoying my time at home before I have to once again become a road warrior.
Let me invite you to meet me in New Orleans at the New Orleans Investment Conference October 30-November 3. This is the grand-daddy of all investment conferences, and they always have a great line-up of speakers. This year Steve Forbes, Ann Coulter, Jim Rogers, Marc Faber, Dennis Gartman and for fun P. J. O'Rourke will be there, along with your humble analyst, as well as scores of great speakers. There is a great deal of emphasis upon gold and natural resources, as well as other types of investments. You can click on this link to register for the conference: https://www.jeffersoncompanies.com/registration/confreg.php?acode=JM
My friends and business associates from Altegris Investments will be there as well, and we will be meeting with clients and prospective clients. Jon Sundt (president), Matt Osborne and Dick Pfister from Altegris Investments (as well as my daughter and right-hand Tiffani) will be there to meet clients and potential clients. Basically, we help clients develop portfolios of hedge funds, commodity funds and other alternative investments. If you would like to know more about what we do, you can go to www.accreditedinvestor.ws and sign up for my free letter on hedge funds that is just for accredited investors (essentially net worth of $1,000,000 or more). If you want to be able to go into specifics about your portfolio with me and Jon or Dick in New Orleans, you must sign up soon and start a conversation with a representative from Altegris at least 30 days prior to the conference. We will not go into specifics with anyone with whom we have not had a substantive relationship for at least 30 days. Those are the rules and we follow them.
(In this regards, I am president and a registered representative of Millennium Wave Securities, LLC, which is a member of the NASD. Please see the specific risk disclosures which follow below as well as those on the website.)
Tomorrow is a special day. #1 son Henry will be 24, and a lot of the clan will be gathering for the celebration. Tonight starts the family gatherings, as my twins are in from college. I always like these times. Five kids are now 20 or older. They are growing up so fast. (two more at 16 and 11.) It is a lot of fun relating to them as adults. I like kids and all that, but the older they get, the more fun they are, at least to me.
Another Friday night baseball game is taking place outside my window, but the Texas Rangers have taken their traditional August swan dive. Something like 12 losses out of the last 16 games. I have had larger crowds at some of my kid's parties when they were in high school. Well, not quite, but there are not a lot of people outside. Oh well, maybe next year we will have some pitching. And the Cowboys and Mavericks are not looking that good on pre-season paper either.
Your still glad he is renting analyst,