House Money

"Despite its severity, we believe that the slump in stock prices will prove an intermediate movement and not the precursor of a business depression such as would entail prolonged further liquidation..."

Harvard Economic Society

November 2, 1929

The average man discovered stocks in the 1990s. At first, he thought he had fallen into the Lost Dutchman mine. But in a few years, the paydirt played itself out. Now, he just digs himself in deeper.

Stocks are down an average of 14% so far this year, and down about 30% from the top. So far, the negative consequences of falling stock prices have been offset by rising house prices and the "house money" effect - the money he was losing was never really his in the first place.

Today's letter, to be continued on Friday, poses the question: how long will this "house money" continue to shelter people from the storm on Wall Street?

"Not very long," is our answer.

Based on the broadest index, the Wilshire 5000, investors entering the U.S. stock market in mid-1997 are now about even. Five years of stock market sturm und drang have left them where they started. No richer. Maybe a little wiser. Certainly older - five years closer to retirement age.

This last detail may be the decisive one. For, when people approach retirement, something happens to them: they become risk averse. A young man - with 60 years of life expectation - will do the damnedest things. He'll drink a half bottle of good scotch and drive down a mountain road as if he thought he was making a moonshine run. Or, he'll jump out of perfectly good airplane...Or enlist in the army just when war has been announced.

An older man has few years to lose, but like a shipwrecked sailor down to his last pack of cigarettes, he guards them carefully. He won't cross against the light...and won't even have a cup of coffee before going to bed for fear it will disturb his sleep...

Imagine what happens to an economy when millions of people grow old at the same time, dear reader. Well, you don't have to imagine. You have only to look at what has happened in Japan since 1989...or wait to see what happens in America in the years ahead.

"It amazes me that most people miss the appalling demographics in the Western World," writes a poster to the Richard Russell website. "This is the thing that keeps me awake at night. By the time a 31 year old retires at 60, almost 50% of the population of the western world and Japan will have retired before him...that is staggering. It should be a long way off but I'm afraid it's not. The average American is 44 years old, has $40,000 in his 401K and has more debt than at any time in history. He has effectively 10 to 15 years to save enough money to retire. If he wants a retirement income of 2/3rds of his salary then he needs to save something like $500,000 over the next 15 years. I'm not quite sure how he'll do it."

How will he do it?

"He'll either have to retire poor or live like a pauper over the next 15 years. Either way, it's not inflationary by any stretch of the imagination," he concludes.

Biology and actuary science converge at around 50 years of age. They soften up a man's brain and his stomach...and turn him from a dynamic risk-taker into a fretful old coot who won't part with a penny without a court order.

A man over 50 doesn't want to wait a quarter of a century for stocks to come back to where he bought them. Rather than take the chance, he typically shifts his portfolio from capital gains to income. His risk tolerance also shifts, from return on investment to return of investment...and his savings strategy drifts too, from just-in-time to just-in-case.

Of course, everything important happens at the margin, as the economists say. The marginal grumpy old man of the '90s entered the stock market along with everyone else. Who could resist such a party? So, along he came - dressed for a funeral but hoping for a good time.

If he got into stocks in 1997, his portfolio is now worth about what it was when he bought the stocks. But in the meantime, his debts increased, his savings went down, and the cost of living rose 12% over the past 5 years. So, he's in much worse shape than the Dow suggests.

"Saving short and overly indebted, the aging American consumer is also closer to retirement, on average, than at any point in the post-World War II era," writes Stephen Roach. "Moreover, with pension fund regimes having shifted increasingly from defined benefit to defined contribution schemes - assets in DC plans first exceeded those of DB plans back in 1997 - the nest egg now looks more precarious than ever. In addition, the equity culture has become more essential than ever to American households in achieving their life-cycle saving objectives. As President Bush indicated in his 9 July speech on corporate responsibility, more than 80 million Americans now own stocks - either directly, in mutual funds, or through their pension plans."

Monday's near-panic on Wall Street could be a sign of things to come. For up until very recently, the average aging patsy felt as though he was playing with "house money". If he had bought before '97 he was still ahead of the game. It wasn't his money he was losing, he could tell himself, it was the casino's money.

Even if he had been holding the big tech - such as Intel, Dell, and Cisco - his positions were still in the black, even after going down 50% to 80% from their highs. But now, the average investor has run out of "house money."

"American households are now hurting big time," says Roach.

"The American consumer remains at the top of my worry list in this post-bubble era. The reason - the perils of what I have called the 'asymmetrical wealth effect.' This rests on the basic precepts of behavioral finance set forth over 30 years ago by Amos Tversky, a renowned Stanford University psychologist. Through experimental sampling of investor responses to hypothetical and actual financial market situations, Tversky found that the loss aversion motive of individual investors made them far more sensitive to reductions in wealth than to increases in their portfolios. The caveat came in what Tversky called 'prospect theory' - that investor responses are also influenced by recent performance. Individuals that only lose 'house money' are less inclined to alter their fundamental economic behavior. Conversely, once the accumulation of losses taps into original investor principal, it's a different matter altogether."

Historical, real returns on U.S. stocks have averaged about 7% per year for the last 200 years. In the mid- to late-90s, investors got used to returns of 20% per year...and more. Now they are five years older...closing in on retirement age...and taking losses - and not just of "house money," but of real money, savings that were intended to cosset gray heads and wrinkled brows.

That these marginal, 50-something investors will panic out of stocks seems a foregone conclusion. Will they panic out of houses too...and out of habit of consumption?

"It is in this broader context that I believe that five years of real wealth destruction have the clear potential to trigger the powerful loss aversion responses first envisioned by Amos Tversky," Roach explains. "Given the demographic profile of an aging American population, saving imperatives are all the more important. That means American consumers now need to save the old-fashioned way - out of their paychecks."

When Americans begin saving like the Japanese, should it surprise us if the U.S. economy turns a little Japanese too?

HOUSE MONEY

PART II

"You have to begin to sell when the householder buys,"

Attributed to one of the Rothschilds

The Fed chairman seemed proud of his work. Speaking to Congress last week, he said that interest rates, driven down to below-market levels by the central bank, had encouraged "households to purchase homes, refinance debt and lower debt service burdens, and extract equity from homes to finance expenditures."

American households took Mr. Greenspan's bait. They took whatever money they had on hand, borrowed more from over-eager lenders, and bought what are usually charmless, flimsy, pathetic, sordid, puerile suburban homes. A few of the more aggressive householders began buying and selling them as if they were dot.com stocks. Now, they have plenty of house, not much cash, and they're on the hook for $2.7 trillion in mortgage debt. What will they want next? More split foyers? More colonials? Ranch, contemporary, Spanish colonial? A McMansion?

Or more cash and less debt?

The average American lives in a suburban house thought to be worth $192,400. Since stocks began to decline nearly 3 years ago, his net worth has not necessarily declined, but it has become less abstract; the poor man now has to live in it. Worse, if things develop as we fear, he'll have to live in it for a lot longer.

But for now, he is as content with himself as the nation's Fed chief. His "investment" in his house has done well - far better than an equivalent in the stock market. He does not notice that his castle of 2002 has no moat to protect it from a bear market in housing.

The Daily Reckoning is free. Since you pay nothing for it, we feel entitled to pass along our gratuitous reflections; sometimes readers find more of them in their morning's DR than in the bathroom mirror.

Readers write almost daily, asking to be taken off our list. Irish, gypsies, gay, straight, Republican, Democrat, frogs - who have we not offended? Tomorrow, we fear...we will hear from the suburbanophiles.

"Single-family homes are selling quickly, prices are soaring, and buyers who square off in bidding wars can end up paying thousands more than sellers have asked for," says the Philadelphia Enquirer.

"Why the frenzy? Low interest rates are the most obvious cause. When rates are low, buyers can qualify for bigger loans, so they can afford to bid higher. Though rates have been low for two years, many people may be rushing to buy now for fear that rates will rise as the economic recovery progresses.

"But they have another reason to rush: fear that rising property prices will put their dream homes out of reach, even if interest rates stay low. This overeagerness to buy is a classic sign of a bubble."

A housing bubble in Philadelphia? It seems almost impossible. Who would want to buy a house in Philadelphia...must less at a premium? But house prices are up in Philadelphia, and even some parts of Baltimore. My sister, looking around rural Virginia, reports that there too it is a seller's market - even in the most benighted areas.

"The five most expensive markets in the nation in order are Boston, where the percentage of income devoted to mortgage payment is 44.9%, San Diego at 43.1%, Fort Lauderdale 29.1%, San Francisco at 47% and Miami at 30.0%.," adds Richard Russell.

"The old rule was that you spend 25% of your income either on rent or for carrying your mortgage. All of these cities are above 30%. This is just one test of housing prices, but I think it's valid. And yes, I do think housing is in a bubble."

When the Nasdaq bubble popped, dot.com analysts moved on - to making real estate appraisals. Thanks partly to their accommodating estimates, suburban America is now thought to be worth about 15% more than it was last year at this time...and twice what it was worth in 1990.

This newfound "house money" has sheltered Americans from the decline in stocks. While stocks lost about $5 trillion since the top, real estate is up about the same amount. Our question in this letter is how much longer this house money will hold up. Our answer, as on Wednesday, is "not much."

A poster on Richard Russell's site: "As a student of bubbles and crashes (am an investment professional who has spent his career in emerging markets), I can tell you that I have never seen a bubble in equities unwound without an unwind in property. For example, Japan, Korea, Hong Kong, the Philippines, Thailand, Indonesia, Mexico, and Brazil. And the unwind generally begins when credit goes south, which happens shortly after an overvalued currency begins to fall, which follows the first leg down of a big, ugly bear market."

Why can't residential real estate just continue to rise - even after stocks head down?

John Mauldin explains:

"If homes were to rise in value by just 7% per year (forget about 10%), in ten years that means the value of our homes would double. If incomes were to grow at 3% per year, the portion that we allocate to housing would have to rise by 50% to be able to buy the same house."

It is all very well for the seller. He watches the supposed value of his house rise up like a drunk from the floor of a saloon. For a brief moment, he imagines himself rich...and begins to daydream about the marvelous retirement in the sun he will enjoy on the proceeds of the sale.

But to whom will he sell? With incomes rising at only half the rate (in John's example) who will be able to buy the house at the list price?

And...who would want to?