Friday, August 8, 2008

The Housing Story Hasn't Changed

Hello all!

I had a chance to hop on late tonight. I will be back next week.

I have some great advice for anyone that is worn out from the turbulence in the stock markets. Take a week off! Get away from it! You will find yourself refreshed and recharged when you come back.

The wackiness that we are experiencing in the markets is enough to rattle any ones nerves. Even the best on the Street are worn out right now. I read an article last week describing how business for therapists in NYC has been booming.

I guess the pigmen need an hour on the couch each week to prevent themselves from jumping off the Brooklyn Bridge.

We had a nice pop today in the markets but I really wasn't all that impressed. The Fannie/Freddie news this week told me all I need to know about the markets going forward. Both GSE's reported MUCH larger than anticipated losses and the housing collapse continues to get worse.

Folks, the housing story will not change until the gap between renting and buying shrinks dramatically. I dug up some interesting research from Haver Analytics. Look at how large the spread has gotten between renting vs. owning as the bubble blew up.

As you can see we still have a long way to correct before these two lines come close to meeting. Housing prices are going to continue to fall until we get back to historical norms. We have decades of evidence as seen above that tells us housing prices got way out of whack with incomes and the cost of renting. To think that "its different this time" is pure silliness.

As home prices continue to correct, the financials will continue to be beaten. Equities will then head south once again. How many bear rallies is it going to take until everyone realizes that home prices must drop dramatically before the stock market EVER recovers?

The bulls keep trying to bury the housing story and it keeps rearing its ugly head. The charts say it all guys! We are nowhere near done correcting. What we have seen so far is only the tip of the iceburg!

The thesis remains the same:

The lending that allowed housing to blow up like a bubble is now all gone. Fannie and Freddie came out this week and said they are basically done doing Alt-A loans. This story hasn't changed folks!

We cannot bailout this problem. There is only one answer. Housing prices must come down in order to attract buyers. Sadly, housing will probably over correct because people panic when bubbles burst and they tend to react by selling at below market value. That "get out at any price" panic is when we bottom. Haver Analytics is predicting we will see this within a year as seen below:

My Take:

The stock market is acting insane right now. Equities are extremely volatile right now due to all of the uncertianty in the marketplace. This is not the place to be right now as a long term investor.

The downside risks continue to outweigh the rewards of higher equities by a significant margin IMO. If you are nimble and savvy enough to play the bounces and trade then go for it. If you are the average investor trying to build a nest egg, I suggest staying on the sidelines for the most part right now. At least be diversified with some assets in fixed income.

New risks are emerging

I see two new risks that are now creeping into the economy:

The first risk is global growth appears to be slowing badly. Europe's economy has come to a complete halt in some countries. China and India also seem to be slowing because we are not consuming like we used to. Remember, a big chunk of Chindia's economy is based on us spending like drunken sailors. We no longer can afford to do this.

As a result of the international weakness, the US dollar has surged because Europe is being forced to stop increasing rates. Anyone that was playing the long commodities/short the US dollar has been creamed the last few weeks. I wouldn't be surprised to see a hedge fund or two go under as a result.

The second emerging risk I see in the economy is the worst risk of all. Its that "D" word and I don't mean Depression. Its DEFLATION. This is the word that the Fed fears more than anything. Anyone remember Japan?

Bonds, commodities, and houses are all dropping in value. Why? Because there is no money to buy them! Look at Gold. Its plummeting. These are all classic signs of a potential deflationary environment.

In my opinion, the deflationary risks to the economy now outweigh the inflationary risks. Demand destruction is settling into everything which results in lower prices on all assets.

Folks, deflation can put the economy into a death spiral where falling values on all assets destroy massive amounts of wealth. This forces the consumers to pull back on its spending. Corporations then take a beating on earnings and layoff people which then makes the initial problem worse. Its also called a "negative feedback loop" if you care to google it.

There is a bright side to deflation. It brings assets back down to affordable levels and we avoid hyperinflation.

The Fed has been fighting to keep this bubble inflated with liquidity in order to avoid deflation. The problem is the owners of this debt(that would be us) have no liquidity to make the debt payments! We are broke. As a result, the debt bubble can no longer sustain itself.

One of the smarter pigmen on the street was discussing this a couple weeks ago. He explained that when the market has no liquidity is when it gets into trouble. This is what happened in 1987.

Bottom Line:

If commodities continue to free fall then deflation must become a big part of your investing thesis. All you "gold bugs" out there beware!. Metals will drop like a rock if deflation kicks in. Who can afford $900 gold when the average consumer has zero savings in the bank?

The market has dramatically changed in the last month. We are bouncing up because the inflationary pressures on companies and consumers has temporarily subsided. Can you say "relief" rally?

The next leg down in the markets starts when the market realizes that the demand destruction that's being seen in commodities markets is also being seen in all parts of the economy.

This demand destruction combined with slower global growth is going to kill corporate earnings. Throw rising unemployment into the mix and you have the perfect recipe for a deflationary disaster.

Stay tuned!