COMMODITY FUTURES FORECAST WEEKLY REPORT
More Shocking Developments
Rob Peebles
(July 24, 2005) How much shock can people take? First, there was the shock of learning that Wall Street was more concerned about investment banking than investment analysis. Then we were shocked to learn that some companies used tricky accounting to deliver spiffy results. And then we learned that the allegedly independent auditors of those accounting statements weren't so independent after all. And now this.
In Wednesday's New York Times we learn that some trial lawyers might have stretched the truth. And just to make an extra buck. Say it ain't so.
But there it is in black and white. Although the Times reporter admits that not all the facts are in, it appears that federal prosecutors are checking to see if some plaintiff firms tried to influence doctors' diagnoses, among other shenanigans, that were related to asbestos lawsuits. According to the Times, plaintiff's lawyers have pocketed about one-third of the $70 billion awarded in asbestos related claims paid through 2002.
Maybe now the defense attorneys will get some of that money.
Speaking of money for nothing, we now know why Americans spend more than German and Japanese consumers. And it's not just because tickets to NASCAR events are so darned expensive. No, it's because our housing prices are going up faster than theirs. And when housing prices go up, people can't help but spend money. Sometimes they spend money just because they figure they don't have to save as much when their ranch home is transforming itself into a castle. Or they may figure that all those radio ads for home equity loans and cash out refis might be on to something. And with all the turnover that comes with a housing boom, there are all those carpets to replace and kitchens to upgrade.
That's why, according to the Economist and their dandy graphic, the faster home prices rose in a particular country over the last four years, the bigger that country's jump in consumer spending. No wonder then that the U.S. is way up near the top right hand corner of the chart (i.e. rapidly rising home prices and red hot consumer spending) along with Britain, Spain and Australia, while Japan and Germany sit and stew in the lower left hand corner, doing things Americans wouldn't dream of - like saving.
It's that relationship between residential real estate and the economy that makes some worriers wonder if the U.S. economy can handle declining - or even flat - home prices. After all, the Economist notes that when housing price gains in Britain recently slowed from 20% to 4%, retail sales growth dipped from 7.5% to 1.3%. Because Americans are more leveraged than those homeowners across the ocean, the magazine figures that the inevitable housing slowdown will hit Americans harder.
They could be right. Money online quotes Paul Ashworth, an economist for Capital Economics, who calculates that 38% of new jobs created these days are real estate related (which he figures to be construction, real estate, architecture, building supply, home furnishing retailers and building services). Yet those sectors account for less than 12% of nonfarm payrolls.
Still there are those who can't see the housing bubble for the granite countertops. They just figure that booming housing prices are a reflection of a darn fine economy and good hygiene. But a recent paper by Fannie Mae (of all entities) does a great job of showing just how different the housing environment is today compared to normal times, like those when people had hobbies collecting Major League Baseball bobble-head dolls instead of flipping condos.
Fannie Mae's expertly crafted Flip Chart of Doom by Thomas Lawler puts into pictures some of the more worrisome aspects of the housing bubble, and it shares some housing bubble trivia along the way. For convenience (or sheer laziness), we'll divide the "pro bubble" arguments into the following categories:
Above average housing price increases Deteriorating credit standards Unusual investor interest Disregard for poor cash flow returns, focus on appreciation
The chart on page 4 takes care of point (a), given that today's real price increases of about 10% are miles above long term real price growth of 1.5%. (Yes, real estate always goes up. It goes up 1.5% adjusted for inflation.) On page 5 we see that housing inflation is outrunning growth in disposable income by a wider margin than Michael Johnson would beat Karl Rove in a footrace. Page 8 shows that houses are selling for more than nine times median incomes in hot California areas, miles above prior peaks.
The increasing shares of interest-only and pay option ARM loans is enough to prove point (b), that lending standards are deteriorating faster than week-old lunch meat. But the clever chart on page 20 presents another angle on this topic. The chart shows that enthusiasm for adjustable rate vs. the prehistoric fixed rate mortgages, historically has been related to the spread between the two. That is, the narrower the spread, the more likely borrowers are to choose the fixed rate - which makes sense since only the most desperate borrowers take on the risk of adjustable rates when they can get the fixed version for a few bucks more. This relationship has broken down in only two periods over the last 20 years. The first was during last housing blow off top in the '80s. And then there's today.
To say that investors are interested in housing is like saying that Congress is interested in spending money. And that's why page 11 proves point (c), with its chart showing that investors haven't been this involved in the housing market since the late 1980's.
The soaring price to rent ratio may be the best indicator of point (d), that today's real estate investors don't give a flip about cash flow. While a recent IMF study has a fine chart of this real estate version of the P-E, the Fannie charts show indirectly this zest for real estate at any price. For example, on page 18 we see that apartment vacancy rates are climbing (indicating pressure on rents, and, given the higher cost of housing, substantial pressure on return on investment calculations). And that's before the toilet needs to be replaced or the A/C goes on strike.
The no bubble bulls have their own case to make for housing, of course. And Lawler dutifully spells it out. It goes something like this:
Demographics remain favorable including new entrants to the housing market. Home inventories remain inline Supply is constrained Employment is improving The economy keeps expanding Interest rates are low Second home buyers and investors boost demand Credit is cheap
The above arguments sound a little like those for perpetuation of the telecom and dotcom mania into infinity, or at least until a third generation of Bushes take office. Back then, the bulls' version of these eight points went something like this:
Demand for broadband will increase indefinitely The internet has eliminated the possibility of inventory recessions There is a shortage of stock due to limited float We are experiencing a productivity miracle (!) The economy is in a New Era of perpetual growth Telecom/dotcom companies can easily raise money in the debt/stock markets Vendor financing creates its own demand Cisco might buy it (!!)
With the bullish news on homes and the borrowing they make possible, last week's report that retailers are expecting a soft back-to-school season sounds like a prank. But according to a survey by the National Retail Federation, families are expected to spend 8.2% less this year on back-to-school items than they did a year ago. The NRF chalked the expected poor showing up to a one-third (!) drop in spending on electronics. While that may be bad news for retailers, the drop in spending could signal great news for parents - maybe fewer gadgets are obsolete this year.
But maybe there's more to this surge in frugality than the product cycle of electronic gizmos. A separate report by America's Research Group also concludes that Americans will spend less this back-to-school season. And half of the respondents said they were trying to get their kids to wear what they wore last year, as compared to a 37% share of incredibly optimistic parents the prior year.
Are parents really tightening their belts? Or are they just waiting for their new home equity line to close? A truly shocking development would be if it were the former.
July 29, 2005
Rob Peebles
www.PrudentBear.com
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