I Kept Buying Stock

Finding good rental real estate purchases is getting difficult, as inventory declines and prices rise. So, while looking for the right property deals, I also kept buying stock. I now have about 45% of my investment assets in the stock market.

Dow: 10,547
S&P 500: 1,128

Shifting My Focus to Real Estate

My stock portfolio has now appreciated to 30% of my investment assets.

A few weeks ago I made my first trades since March, selling almost half of my BAC stock and putting that money into the broad Vanguard Total Market fund (VTI). The market has declined since then. Good for my sale of BAC, but bad for my other stock.

I expect the stock market to be a good (but not great) place to be in the next few years, so I will leave my money in the market for a while.

The time has come to buy real estate again. So, now I am buying bank-owned properties during this time of low prices.

Real estate is now 40% of my investment assets.
Cash is the remaining 30%.

Enjoying the Ride

Having sold most of my stock before the long decline, I largely avoided the losses that dominated 2008. I am very glad to have dodged that bullet.

I bought back in (partially) during October through March (mostly while the Dow was around 7000). Stock is now 25% of my investment assets, and I have no desire to invest more than that.

I have made no trades since the end of March. I am now just enjoying the ride.

Dip and Rally

That was quite a slide and recovery. The Dow slid to 6547 and then came back again.

I did buy a little more stock on the dip, and I will slowly buy a little more on future dips.

I now have about 15% of my money in the stock market.

Dow 7366 and falling

I continue to expect further declines. However, with the market dip this last week I decided to buy some stock. I did this in the spirit of dollar-cost averaging. I only added about two percent of my net worth. This was not enough to offset the decline of my portfolio over the last few months. At this point I have about 11% of my money in the stock market. I will slowly increase that as this bear market continues.

Deflation – Cash is King

The dollar buys more stock and other assets than it did a year ago.

The price of real estate has fallen from its bubble high…
The price of oil has collapsed from its bubble high…
The prices of most commodities are down…

Generally, the prices for many of the inputs for production are down significantly and will enable producers to reduce prices during 2009.

Demand is down, forcing sellers to reduce prices.

Prices will decline for a while.

However, the Fed has poured massive liquidity into the system.
At some point that will be reflected in rising prices.

I expect deflation for about six months. Then the tide will slowly turn, and the beginning of strong inflation will become visible during 2010, and gain momentum in 2011.

Waiting for Dow 7000

New lows and more bargains...

For about a year I have been hearing that stocks are a bargain, cheap - and that I should buy back in. And mostly I have replied “No thanks, I think they will get even cheaper”.

However, after the plunge I did buy some. Now those shares are cheaper and better bargains than ever before.

Thankfully, I put only a small share of my money back into the market. Unfortunately, the market has made that small share smaller.

I do believe there is value in dollar-cost averaging in the low end of the market. However, I am going to wait for a while. I think I will not buy again until the Dow is around 7,000.

Is The Bottom Near?

This was a wild week. A record one week drop in the Dow. And prices moved dramatically from hour to hour. Fear and Panic were high.

Fortunately, I started the week with only 7% of my money in the stock market (perhaps 7% too much). Today I added significantly (6% of assets) to my stock position as the market hit new lows. This combined with small additions earlier in the week doubled the size of my stock portfolio to 14% of my investment assets.

I would not be surprised to see the Dow bottom somewhere around 7,000. However, I do expect at least one good rally in the last few months of this year. It is not realistic to pick the absolute bottom amount or timing. But I do believe stocks will be much higher a few years from now, and I see the current market panic as a buying opportunity.

Having removed most of my money from the market before the declines began, I am now buying back in on the dips to dollar-cost average into this low period in the market.

Big Declines Yesterday

Stocks seem to be getting cheap – especially banks. I bought some more financial stocks yesterday on the dip (BAC & XLF), and again this morning. Sort of a dollar-cost averaging approach on market lows. Still, I have only 9% of my money in stock.

This may not be the bottom, but long-term the current prices should look good.

Cash is King (Put Your Helmet On)

The bailout is a rip-off of the taxpayers. It would be more effective and less expensive to simply guarantee all bank deposits. In the end we will have to do that anyway. So why give $700 billion to the Wall Street speculators who were foolish enough to buy the bad assets.

Anyway, the optimism of the pending bailout/giveaway created an opportunity to unload some stock… so, I sold a bunch of my stock into the pre-bailout rallies. Mostly I sold the last of my company stock, and also my GE and KBH. I continue to hold BAC, USB, plus the misc mix in my 401k accounts.

I also hold some dollar notes that I bought in August (I should have bought in July). They are a bet on the US dollar rising vs. the Euro, GBP, CAD, and CHF. So far so good.

At this point I have only 7% of my investment assets in the stock market. I continue with 36% in rental properties, and the remaining 57% is in cash.

When I believe we are at the bottom I will buy for the rally. I do anticipate a rally this year, followed by a return to current lows or lower prices thereafter. I expect the stock market to have a fairly slow and weak recovery after the final, real bottom is found.

Betting on Financials and a Rally

I have been buying financial stocks on the bad news dips, and holding them. I think they are cheap, and a good long-term play. I bought on the bad news dips in July and August - especially on Aug 26 when I bought BAC, USB, GE, and KBH. And last week on Monday I bought more BAC on the bad news of AIG.

I also day traded on Monday. I bought AIG on Monday morning at about four bucks and sold it a few hours later for about five bucks. At one point I could have sold for over six bucks, but I got greedy and was hoping for seven or eight. When it started dropping I got out at $5.15 per share.

On Tuesday a hedge fund principal told me over dinner that I was very brave to buy BAC on Monday. I think he really meant that I was foolish. But I am now up about ten bucks a share since Monday, so I am not feeling so foolish. Perhaps I should sell now, take my profits and repurchase on the next dip.

However, I continue to expect a mild market rally into the end of the year, followed by a continuation of the bear market. I expect stocks to bottom sometime in 2009, with the Dow under 10,000.

I retired this summer which enabled me (politically) to sell some more company stock - and I did. I wish I could have sold more of it earlier.

My current allocation of investment assets is about 46% cash, 36% real estate, and about 18% stock. My stock position is heavily in the financials, and financial sensitive stocks.

I am still waiting for the bottom in stocks and real estate. I intend to go very long in both as the markets recover.

Economy Now Over a Barrel

The price of oil has doubled in the last 12 months to almost $139 per barrel. The persistent high oil prices have become too much for the economy to overcome. This is a significant detriment to the previous outlook. It is a growing second wave of trouble that will sink/delay the recovery enabled by monetary policy.

I now expect the mild recession to deteriorate into a real recession. Unemployment will likely hit 6.5% by year end, and persist at a similar level into 2009. I expect a slow recovery.

Still waiting for the bottom with about 50% in cash.

The Near-Recession is Almost Over

A mild recession or no recession – it is hard to tell. But job losses are easy to measure. And the economy is not growing fast enough to keep pace with population growth. So, on a per capita basis I say it is a recession.

I expect this mild recession to recover slowly (nearly flat and perhaps with a second dip). However, unemployment will continue to rise into 2009 as companies will be cautious about expanding their payrolls. The level of unemployment will be mild compared to past recessions, but people will squawk like it is something worse than ever.

This is a very mild recession. But we are now so spoiled that anything less than perfection gets people agitated. Americans have become so self indulgent and spoiled that any reduction of their wasteful gluttony is unacceptable.

Most Americans today have never experienced a difficult economic environment. Our worst years in recent decades are better than any of the best years from a generation ago.

Those who have never felt pain are the least tolerant of it.

I Sold My Treasury Bonds

I have sold all of my Treasury bonds this week. Anticipating a decline in Treasury yields, I bought them in 2006 (before the financial trouble started), so I have made a nice gain – almost a 15% annual return. Not bad for a 5% coupon investment!

Motivated by fear, many people had moved their money to the safety of Treasury bonds during the last year or so. This has driven the prices up and the yields down (from 5.25% to about 3.5%). I believe that the worst of the financial panic/fear is behind us now. As such, I think people will start to sell their treasury bonds and the yields will rise.

I expect the economy to continue to struggle for a while - especially during the second quarter of 2008. Unemployment should rise to at least 5.5% and possibly 6.0% before things get better.

Housing will not recover this year. Construction and new home sales will remain slow, and housing prices will continue to decline. I expect the recent rally in homebuilder stocks to reverse itself as the spring sales of new homes disappoints the optimists who bought the stocks.

No need to be a hero. I continue to wait - with half my assets in cash.

Still Waiting for the Bottom

I continue to expect the worst of this storm to be during the first half of 2008. I believe that we are now hearing the worst of the bad news.

The Fed actions this week have given the stock market a dose of enthusiasm. This should soon fade. The average guy is just now beginning to dump his stock positions (401k, mutual funds). We will not see the market bottom until the average guy has given up on stocks.

The homebuilder stocks should soon be confronted by the continued lack of home sales, and will probably drop significantly in a few months. Home prices will continue to decline for a while.

Commercial real estate prices have peaked and rents will start declining as vacancies rise from businesses needing less space with their reduced employment, and as new office space comes into the market.

Nothing looks safe or good to me, so I continue to wait - with about half of my investment assets in cash and Treasury bonds. I will probably sell the Treasury bonds in a few weeks at a premium of about 15% over what I paid for them about a year ago.

My Expectations for 2008:

2008 will be the weakest year of this business cycle for GDP growth, and corporate profits. The economy should get stronger in 2009.

Unemployment should rise a bit – to at least 5.0%.

Inflation should be modest for most consumer goods. However, I expect food prices (especially for grain and meat) will continue to rise more significantly.

Interest rates will decline further during 2008. My targets are 2.5% for the 2 year Treasury, 3.0% for the 5 year Treasury, and 3.7% for the 10 year Treasury. I anticipate that the Federal Reserve will need to lower the Federal Funds Target Rate to about 3.25% during 2008.

Home prices (in the previously “hot” markets) should decline a little faster during 2008 compared to 2007. I expect further (but less severe) price declines during 2009. This should be followed by a weak recovery during 2010.

Homebuilders will have a terrible year as new home sales decline in 2008. It will remain tough for them in 2009.

Homebuilder stock prices should fall a bit further during 2008, perhaps finding a bottom in 2009.

The stock market will be bumpy – likely down for a while, but possibly ending the year with a small gain. An irrational but short-lived bull run is possible this year.

Financial stocks should bottom during 2008.

The dollar should end its slide during 2008.

The Gathering Storm

The storm is gathering. However, I do not expect economic collapse, but the trouble will be large and widespread – as it was in the last major cyclical downturn.

Every cycle has this type of problem to varying degrees. The details change but the theme is the same. 20 years ago it was the failure of more than 1,000 savings and loan associations. 10 years ago it was the Asian financial crisis and the Russian bond defaults. This time it will be hedge funds and SIVs.

These are the financial symptoms and manifestations of the economic cycles. The world will not end – though many will think so and dump their assets at fire sale prices (God bless them, every one).

The geniuses at the hedge funds bet the farm and make huge fortunes as long as things go well. They blend their sophisticated instruments into packages of “uncorrelated” risks.

However, it turns out that the uncorrelated risk becomes correlated because everyone bought the same stuff, and will try to sell their uncorrelated assets at the same time – with disastrous results.

I have been expecting financial turmoil and cyclical decline. Back in 2005 when I thought the real estate market was peaking and about to slide, it was actually a bit more over-priced than I thought. The decline will likely be worse than I predicted at that time. I had expected a price decline of over 20% in places like San Diego and Los Angeles - I now think it will go deeper.

In late 2006 I forecast that the 10 yr treasury would decline to around 4% by the end of 2007 (it has), and that it would go lower during 2008 as the economy becomes sluggish into 2008. I bought 5yr and 10yr treasury bonds when the yield was around 5% - with the yield now under 4% they have gained in price. I did a similar strategy during the bear market from 2000 through the end of 2002 – a time when I lost no money on stock because I had sold it all before the decline.

During the last year I have sold about 70% of my stock – selling into the rallies this year. My average selling price was about 15% higher than the current market prices. My last sale was in late September. I will soon sell a little more (into rallies), and then I will wait for the bottom to come. There will be great bargains to be had.

The shit is hitting the fan and will likely get much worse for stocks and real estate for another two years. The party is long gone for real estate, and I believe it recently ended for stocks.

Batten down the hatches for the big storm, and keep your cash dry.

Batten Down the Hatches

At the end of September I sold some more stock into the rally, and I will likely stand pat for a while. So, my current asset allocation is 46% cash, 36% real estate, and 18% stock. I think the party is over for a while, and I am now waiting on everything.

I think the worst of the credit crunch is passing now.

However, I think a recession or near-recession is finally upon us. The worst of this sluggish period will likely be in the first half of 2008.

Update

So, I started buying back into the market a little bit recently (mostly GE in late Aug and early Sept, as a long-term play). I stopped buying when I saw the market rally in advance of the Fed meeting. My current asset allocation is 38% cash, 36% real estate, and 26% stock.

I was hoping the Fed would disappoint today, causing a market dip and a buying opportunity. Instead the market shot up. However, I expect the excitement will be temporary. The economy should slip a bit more in the coming months, and the stock market will likely slip with it for a while.

I expect improving conditions later next year. This will give support to stock prices and also push treasury rates back up somewhat. So, while I may sell some stock in the current rally, before long I will increase my stock market exposure for the recovery. However, longer term (by 2010) I will push most of my money into real estate. I will fund this with cash and by substantially increasing my debt, without selling much of my stock.

My Forecasts are Looking Good

Last year in October I posted some forecasts for my investment assumptions (see my post from that date). So far they are nearly all happening. The significant exception is the price of oil. I still think it will decline significantly, but the timing will likely be later than I thought last year.

Otherwise, I was right. Inflation has subsided, the economy did slow to about a 2% growth rate, unemployment looks poised to rise, yields on the 10 year treasury are nearing my target, commodities have peaked and are declining, and residential real estate prices are declining by about as much as I predicted.

Many people have incorrectly called the bottom for residential real estate, and many thought we would see a soft landing. At various times over the last 12 months housing bulls have said it was a buying opportunity in the homebuilder stocks and that home prices would recover this year. They have been very wrong. The homebuilder stocks are much cheaper now, and home prices continue down. In addition, the mortgage companies have also suffered significantly in the recent tumoil. As I posted a year ago, there are no soft landings in real estate.

Tough Day - Tough Week!

Wow! After today’s market declines I am glad I cut my stock position a few weeks ago.

My current asset allocation is 42% cash (and Treasurys), 36% real estate, and 22% stock.

I am starting to regret not selling the last of my stock.

Peak Oil

Every oil field has a finite supply and its output reaches a peak and then declines. It is sensible to believe that the collective supply of all the world’s oil fields would do the same. Of course, new oil discoveries change the calculation. But, it is impossible to know how much oil remains undiscovered.

All my life I have been hearing about the end of oil. In the 1970s the prediction was that we would run out of oil around the turn of the century. So, we should be freezing in the dark by now, with our useless vehicles all abandoned. But, with each new oil field discovery that day of reckoning keeps getting pushed back.

Is the end upon us? Here is a quote that provides an interesting perspective on the timing of this crisis:

“The question of the possible exhaustion of the world’s oil supply deserves the gravest consideration. There is every indication that we are face to face with this possibility.” - Scientific American, 1913

It seems that the end has been near for a very long time.

Finally, The End Game Begins

Inflation fears are rising. However, inflation is not the main risk - business does not have much more pricing power. Rising business costs will mostly squeeze profit margins - rather than push prices.

Stocks are fully valued – perhaps overvalued. However, the small investors are still bearish and standing on the sidelines. The market will probably not top out until they have joined in. The market may very well ignore the profit squeeze as the little guys and other bears capitulate and drive the stock market to another unsupportable peak.

The recent hints of a recovering economy will prove temporary or false. 2007 will end with a slow economy, and 2008 will be a difficult year.

Goldilocks May Soon Go Home

The economy is slowing. The fundamentals forces that have boosted GDP are waning. This should lead to declining growth as the year progresses. I expect that weakness to continue into 2008.

A good barometer of economic health is the relative level of interest rates. This includes rates relative to inflation, and relative to differing types and durations of debt.

Short term rates are particularly significant in their impact. The Federal Funds Target Rate and the Prime Rate are good measures of the short-term rate environment. Both were cheap until 2005, and both have been expensive since the beginning of 2006.

The Fed Funds rate is normally at equilibrium when it is about 150 bps below the ten year treasury rate. Today it is about 50 bps above it. This indicates that the Fed Funds rate is about 200 bps above the natural equilibrium level for current economic conditions. Clearly this is a significant negative factor for economic growth.

We are beginning to see the effects of this expensive level of real short-term rates. The housing market, which was boosted by cheap rates and buyer euphoria, is now being slowed by expensive rates and buyer hesitation. The excess supply of homes for sale is causing a slowdown in construction. Construction employment and other housing related employment is declining and will become a growing drag on the economy.

Soon the risk spreads will widen, causing credit to become more expensive for business and investors. This will exacerbate the slowdown.

Consumer spending should also soften a little as these factors work through the economy. This will also lead to softening of employment and further slowing of spending.

The Fed will respond by lowering the Federal Funds Target Rate. After a while this will begin to have a positive effect. But it will be too late (it may already be too late).

The net result is a slowing economy that could stagnate for a while, or even go into recession. The usual lag periods from the causal factors suggest that the worst or slowest period will be late 2007 through early 2008.

Let it Ride

I have made no trades for more than 60 days. I am just riding the rally with my existing positions.

Four months ago I was hoping the rally would last for another six months. So far, so good.

Let it ride.

2006 Asset Allocation

At the beginning of 2006 my investment assets were 58% in stock, 38% in real estate and 4% in cash. At that time I had debt equal to 21% of assets.

During 2006 I sold stock and real estate, and used the proceeds to reduce debt, buy treasury bonds and increase cash.

Today my asset allocation is 42% stock, 32% real estate, and 26% bonds and cash. My debt is now down to 11% of assets.

My Investment Assumptions

Investment Assumptions through 2007:

Inflation should peak sometime during the next six months and slowly decline during the rest of 2007.

GDP should grow at a 2% pace during the first half of 2007, with a flat or mild decline observed in the second half.

Employment should decline in the second half of the year – unemployment may rise throughout most of the year.

Yields on the 10 year Treasury bond should decline to nearly 4% by the end of 2007. Yields on junk bonds will rise.

Commodity prices for building supplies such as lumber, cement, and copper will decline significantly.

Oil will decline to under $50 per barrel by the end of 2007. This is a cyclical decline within a longer term rise.

Residential real estate prices will decline by about 10% during 2007 in major cyclical markets such as Los Angeles. The declines will be very uneven depending on the area and type of housing. Condos will decline by more than houses. Florida condos will have a bloodbath.

I worry that the current strength of the stock market is a sucker’s rally. I hope it lasts for another six months or more. However, I will continue to slowly sell into this strong market, and then sell more quickly if I see the decline that I am expecting.

The Dow Marches On

Since my June 13 post, I have been pleasantly surprised by the strength of the stock market. I had expected a mild summer rally, but thought it would have been weaker and be fading by now. Of course, I have been a little early in calling previous stock market tops. That is part of the reason that I have been selling only slowly into this market. I have now sold more than 25% of the portfolio that I held before March.

I remain convinced that we will see continued and substantial declines in residential real estate prices, commodity prices, and the yields on Treasury bonds.

The great asset run is over (for this cycle) and a recession is approaching. Soon the stock market should reflect this.

Why Tax the Rich?

The reason for taxing the rich is the same as the reason for robbing banks – because that’s where the money is.

There is no realistic alternative.

The real issue is how to tax the rich.

Should we tax income productivity?
…or tax the luxury consumption lifestyle?

Who pays the Income Tax:
http://www.ntu.org/main/page.php?PageID=6

Convert to Islam or Die

Angry at the Pope’s comments about Mohamed, Muslims went on a rampage of violence - fire bombing non-Muslim churches. It seems that the Pope’s comments about Islamic violence prompted more Islamic violence.

When will the peaceful followers of Islam do something about the radical murderers among them? Probably never - because the violence is against non-Muslims. Mohamed himself said that Islam should be spread by the sword.

The Muslims are not the first (nor will they be the last) to spread religion by the sword.

Jihad ...

They hate us ...

They want to kill us ...

They are happy to die trying ...

They are developing nuclear capability ...

We had better get our heads out of the sand ...

... before it's too late.

There Are No Soft Landings – But How Bad Will This Housing Downturn Be?

We are in the early stages of a real estate downturn. Many have claimed that this downturn will be far worse than any before because prices have increased so much. But is it really that simple?

Cycles can not be properly evaluated within in the context of short time periods. One must look to longer periods of time to establish a norm from which to evaluate recent conditions.

I have selected the period from 1970 to 2005. This period provides a long enough timeframe to include four real estate booms and three full downturns. In addition, I believe that our current economic environment from a market cycle standpoint is fairly similar to what we saw in that general time frame (post stock market boom, real estate boom, and an oil shock, unpopular expensive war, rising inflation). Of course, the differences are many as well.

Over the last 35 years nominal GDP per capita has increased eight fold. Mortgage rates are lower today than 1970 (6% vs 8%), and new houses have increased in size by about 70%. The median house size has increased by about 30%. The combined effect of these facts suggests that housing prices should have increased by about 50% more than nominal GDP per capita. This would suggest that prices today should be about 12 times what they were in 1970. However, they are now only 10 times the level of 1970. So, as expensive as housing is today, it was even more expensive relative to income in 1970. This suggests that the market stress in 1970 was greater than it is today.

Our society is significantly more affluent today compared to the past. Viewed on an inflation adjusted basis (in 2000 dollars) we see that GDP per capita has doubled since 1970. In 1970 real GDP per capita was $18,491, and by 2005 it had doubled to $37,232.

Here is a link:

http://eh.net/hmit/gdp/

Of course, this tells us nothing about the distribution of this tremendous growth in affluence. But it does shed light on why homes and other assets have appreciated so much in nominal and real terms.

The boom is over, and there are no soft landings in real estate. However, I doubt that this downturn will be much different from the average.

Has The Fed Gone Too Far?

It is difficult to judge the Fed without knowing what would have happened if a different policy course had been followed. But I think that the Fed always overreacts. Whatever the “right” policy is, they will do too much of it. This in turn requires them to be heavy with the antidote to their preceding mistake.

The huge liquidity move in 2001 through 2004 was excessive. And to the extent that it was excessive and lasted too long it was damaging. I think they should never have gone below 2%, and 2% should have been a six to 12 month affair with rates coming back up by the end of 2002. Instead they went lower (to 1%) in 2003 and stayed there until mid 2004. So the pot boiled over.

If only they would have the patience to wait for their medicine to take hold before upping the dose. They know that the lag time is about 18 months for peak effect on GDP and about nine months for the first real impact of their policy changes. And yet they get impatient and keep upping the dose.

The recent economic conditions are largely the result of last year's rate policy - when the target rate was still around 3%. Imagine how the economy will slow once the recent rate levels begin to kick in!

Now (at 5.25%) the Fed has already raised their target rate well above the natural equilibrium level. This is more than enough “medicine” to slow the economy, but it will take a while for the medicine to be digested. Any further increases will intensify the recession that will come soon (2007).

The Great Asset Run is Over

The bear market in real estate started last summer.

The bear market in stocks started last month.

The bear market in commodities seems to be upon us.

A recession is just around the corner (2007).

The great asset run is over.

Boomers Will Not Inherit The World

It has been claimed by some that the baby boomers will be inheriting large sums that they will then invest in real estate. However, this is not likely as pointed out in an article in the New York Times today. The median inheritance for all heirs in the U. S. in the last two years was about $29,000, and it seems that the median for boomers will be only $19,000. So splurging on a new car is more likely than a new house.

Not only will most baby boomers not inherit much, most of them are terribly under-funded for their own retirement needs. This means that most boomers will be short of income when they retire, and will not be a source of extraordinary buyer demand at that time.

Supply and demand has generally worked against the average boomer. Because there are so many of them, the large boomer generation has overloaded the system every step of the way. This has also meant that they generally had to compete in an overcrowded job market – there were always too many applicants for the next job desired by a boomer. It is not surprising then that so many are falling behind. Combine that with a “consume it now” culture and attitude and you get skimpy savings accounts.

Boomers now occupy the age bracket where incomes and consumption reach their peak, and many are indeed very affluent and spending like there is no tomorrow. But most boomers have largely missed the affluence boat – they continue to muddle along in the crowd.

Demography is Destiny

In the long run the demand for housing is driven by demograhic factors including household formation and incomes.

On an inflation-adjusted basis household incomes in the US have increased substanstially and fairly steadily for many decades. To get a closer look household income distribution is divided into five 20% bands. Using this data we find that incomes have increased at a faster rate for the upper bands than for the lower bands.

The data is presented on a nominal (current dollars) and inflation-adjusted (2004 dollars) basis on this Census bureau web page: http://www.census.gov/hhes/www/income/histinc/h03ar.html

Note that real income has increased substantially in every income band over the decades through 2000 or 2001, and then slipped a little in the last few years.

Housing prices are heavily driven by the upper income bands. Generally, the middle band is the source of first-time buyers, while the upper bands are the trade-up buyers and second home buyers. The bottom two bands are predominantly renters.


But what about the future real demand or real need for housing?

By looking at population distribution by age we can forecast the real housing demand for many years into the future. Here is a graphic display of population by cohort:
http://www.nationmaster.com/country/us/Age_distribution

Note the steady increase in the forecast of adult population in the coming decades. This is not speculation – the people are already born for the 2020 forecast. If you slice this data carefully and evaluate the propensity to own by age cohort, the result is not only a rapid rise in household formations in the next 10 years but also a strong rise in expected homeownership through the next 20 years.

However, none of this precludes cyclical downturns.

For the benefit of housing demography buffs with insomnia, here is a Census report that gives some interesting perspective on population trends. http://www.census.gov/prod/2002pubs/censr-4.pdf

Is the Sky Falling?

The real estate cycle is turning. How bad will the bust be?

Busts are always a function of the excess that precedes them. The greater the excess, the greater the bust. The classic example is the Great Depression which followed the roaring twenties. In the 1920s we had wild speculation in stocks. The resulting bust was deep.

While the Great Depression was terrible, it need not have ever been so bad. The Fed followed a severely restrictive monetary policy in response to the stock market bubble in order to “squeeze the excess” out of the economy. Unfortunately, they turned a serious downturn into a supreme disaster.

In the 1990s we had a similarly risky scenario in the wake of the housing bubble of the 1980s. In response the US implemented stimulative policies and we averted the disaster. At the same time Japan followed the restrictive policies of the same type that we had foolishly used during the 1930s, and they have suffered a similarly disastrous result.

Such severity will not happen here again unless we restrict the money supply too severely. So far the Fed has avoided that blunder, at the expense of some overheating.

The prolonged real estate bust of the 1990s followed upon extreme excesses in the 1980s, the worst of which we have not yet seen this time. Remember that the Savings and Loan Crisis of the 1980s started about four years before the real estate market peaked. We had many savings banks already going insolvent at least three years before the real estate market peaked. The market was so bad in the 1980s that the Federal S&L Insurance Corp. was also declared insolvent – TWO YEARS BEFORE the real estate market peaked. And the bubble marched on.

After four years of financial collapses by banks, builders and property owners, the Federal government created the Resolution Trust Corporation to engage in an orderly disposition of all the troubled assets. That was during the very same year that the last of the major bubble markets peaked (1989).

We have not seen any of these severe symptoms in this cycle. If we do it will take several more years of such continued excess to get just as bad. Pray that it never happens. Fortunately, it looks like this cycle will end before any of these really severe excesses occur.

Reversion Toward The Mean

Will we see a reversion to the mean in housing prices?

Like most people, I believe that markets tend to revert toward the mean. However, the key question is determining the future mean value toward which the market will revert. The market mean shifts with time as the underlying fundamentals evolve. What was a valid mean a few years ago at higher interest rates and lower GDP will no longer hold true today.

Look at some other areas for comparison -- medical expenses have risen faster than GDP and inflation for decades. Must these costs collapse in order to revert to the mean? Not likely. The economics have evolved – the mean value has shifted. How about college tuition, which has increased even faster than medical costs? Will there be a collapse in tuition prices to revert to the mean? No. There are sound economic and demographic reasons for the continued real increase in tuition prices. The mean value has shifted.

People who currently forecast serious housing price declines do so based primarily on the fact that prices have gone up so much, along with easier credit and speculator activity. These are all significant considerations. However, it is not enough to focus on the imbalances that come with the temporary exuberance near the cycle peak. One must also examine the evolving nature of the fundamentals that drive real housing demand. There will be a cyclical decline, but how far depends not only on the current frothiness but also the underlying enduring fundamentals.

While the easy credit and flippers have been getting all the attention, nearly all of the bubble trackers have neglected to look at the shifts that are taking place in our economy and our population.

If you study the demographic profile of our country you would see that the age distributions are such that we are about to experience a significant increase in household formations, and an accelerated shift toward higher average age of the population. The propensity to own goes up with age, as does income and wealth. This means that we will have significant growth of real demand for owner-occupied units in the coming years. So the mean value has been rising underneath this frothy market, and will mitigate the magnitude of the decline.

Real Estate Cycles -- The Nature of Declines

In all notable cyclical downturns since WWII, prices have declined at a fairly steady rate during each year of the decline, and at about the same “real” rate in each cyclical decline. The inflation adjusted decline has typically been around 8% per year. Usually this means about a 5% nominal rate of decline.

The declines have lasted about three years in every decline, except during the real estate depression of the 1990s, when the decline lasted about six years. Even during that longer decline the real rate of decline was about the same as during the previous declines (same rate but more years). The one notable aberration that I know of is the Great Depression, where prices declined for about four years and at a greater rate.

When will the market peak?… Except in specific localities, the housing market will not have a single month that can be identified as the peak. The last few declines demonstrate the rolling nature of the declines. The various markets reach their peaks at different times, and then decline in the standard pattern. The rolling peaks have been spread over a period of about two years during these prior cycle declines.

The cycle of fundamental economic factors driving the various markets have also varied by about two years. The local price cycles have tracked with these factors… no surprise there. However, the economic fundamentals in the various markets are currently very closely synchronized. Because of this I expect the window to be much tighter this time. I am estimating a one year spread for the rolling peaks.


P.S. These comments pertain only to the "hot" cyclical major markets.