A host of technical indicators suggest that the stock market reached a major top in May 2006. Both momentum and volume broke rising bottom patterns, indicating the bull market of the last year and a half had come to an end — at least temporarily. For the long term the outlook is much worse.
Market indicators are aligning with the larger economic picture, suggesting we are entering a secular bear market cycle that will see overall flat markets for the next decade. The last decade of economic growth was on the back of an incredible borrowing spree by the American consumer. In 1989, the savings rate in America was 9.5%. Now, it’s -1.7%. This cycle of borrowing didn’t begin with the housing market, but the mortgages and home equity loans taken out through the last several years almost assuredly ended it.
The “get rich quick” mentality of the 1990s is associated with the Internet bubble, but the dot-com collapse wasn’t the end of the story. The people who got burned by the dot-com bust didn’t stop believing the right investment would make them rich overnight, they simply stopped believing that investment was Internet stocks. Instead they switched to houses.
Two bubbles back to back may seem illogical at first, but history says that is exactly how markets work. The last major world bubble, the Japanese stock market, was sandwiched with a bubble in the Japanese real estate market that burst two years after stocks. Sound familiar? In the 1970s, America experienced back-to-back bubbles in oil and gold. One bubble feeds on another because bubbles can only occur when speculation by ordinary people runs rampant. A societal fever for the “can’t miss” golden opportunity is a prerequisite for irrational market advances of all types.
In housing, as in Internet stocks, spectacular rises in price were fueled by speculation by both professionals and the general public, not fundamentals. Since at least 2002, there has simply been no substantive support for the runup in housing prices. Inflation was historically low, gross domestic product (GDP) growth was moderate, wages were stagnant, the wealth of the middle class was battered by a bear market, and our population rose no faster than it has for the last 30 years. Housing prices, on the other hand, were through the roof.
By any traditional valuation, housing prices at the end of 2005 were 30% to 50% too high. Others have pointed this out, but few have had the nerve to state the obvious: Even if wages and GDP grow, the national median price of housing will probably fall close to 30% in the next three years. That’s simple reversion to the mean.
The decline has already begun and is reflected in the adjusted annual rate of housing sales (see “Topping off”). The momentum of the rally has been broken, even if prices don’t reflect the significance of the change yet. As soon as the market takes out the bargain hunters and dip buyers, it will begin its first significant leg down.
Right now, the stock market seems interested in the problem but is remarkably unresponsive. The damage has been confined to home builders, but it will spread. A slowdown in construction affects a broad range of suppliers. An estimated 9.8% of Americans were employed in the real estate business in 2005, and that doesn’t include undocumented labor. A downturn in their fortunes will further sap a weak economy.
But the real problem in real estate isn’t with the new homebuyers; it’s with the people who already have homes. Too many of them have made one of the cardinal sins of economics: they’ve financed a long-term asset with a short-term loan.
Most home owners can’t afford the homes they purport to own. They have been trapped into buying above their means by bubble-induced prices and adjustable rate financing. Even people who have owned their houses for years have borrowed against the appreciation, putting many of them into the same bind as those who bought at the top. Impossibly low rates are tempting, but unfortunately the bills always come due.
The cost and risk of adjustable rate financing is devastating. Within two adjustments, a monthly mortgage payment on a typical $250,000 adjustable rate mortgage with a 2% rate hike cap will rise from $1,123 to $1,748, a $625 per month increase. That’s $7,500 more per year just to maintain the same mortgage. If you think high gas prices are biting the consumer, consider mortgage adjustments.
Now consider that, according to Federal Reserve Chairman Ben Bernanke’s comments to Congress on July 20, at least 20% of all mortgage holders have an adjustable rate loan —and half of those loans (about a $1 trillion worth) will adjust in the next year. And that’s the tip of the iceberg. About 32% of new mortgages in 2005 were interest only, up from 0.6% in 2000. And 43% of first-time homebuyers in 2005 put no money down. Ultimately, 10% of all home owners with mortgages have no equity in their homes.
These numbers may sound preposterous, but the reason for them is worse. At the height of the bubble, lenders encouraged people to use the appreciation in value of their house as collateral for an unaffordable loan. The only way home owners can stay ahead, from an investment view, is if their home appreciates faster than their costs — but the payment on a typical adjustable rate loan is going to rise 50% in the next couple of years. And it’s going to be significantly worse for option ARMS and interest-only loans.
Housing prices aren’t going up significantly from here. Analysts can crow all they want about a rise in sales and small upticks in prices, but a market with 50% more inventory to sell than it had a year ago, a consumer base that is dangerously overstretched and questionable receivables that account for at least 90% of sales is dead in the water.
NO WAY OUT
Without huge price appreciation, there is no way out for the strapped homeowner. Switching to a fixed mortgage takes tomorrow’s unaffordable costs and makes them payable today. Selling in a falling market, especially if you have no equity in a home that has declined in value, is an unattractive option most owners won’t take — yet. Most strapped borrowers are simply holding their breath and hoping interest rates go back down, but any rate decrease will be way too little and way too late.
Just as bad, there is no way in for the next crop of buyers. Banks are approving far fewer high-risk loans and appraisers are starting to lowball. A tightening of credit standards is good in the long term, but in the short term it drives down the number of eligible buyers and traps those already in a credit bind. It is the leading edge of an inexorable force pushing the largest number of Americans in history toward foreclosure. Those able to pay will be saddled with a financial white elephant for years if not decades.
The fallout in the housing market will probably take three to five years to reach bottom. The fallout in the stock market will come much sooner. The stock market doesn’t wait around for something to happen; it calculates probabilities and anticipates consequences. If the market foresees a problem in housing, it will fall earlier, faster and farther than the price of houses.
It is impossible to predict when investment professionals will wake up to the disaster in the housing market, but when they do, the stock market will probably begin a 25% to 30% decline. It would not be surprising for the market to trade at its 2002 lows.
A long decline is one thing; a short decline is another. The speed of market declines is a function of the difference between expectations and reality. The gap between expectations and reality in the housing market are the most serious in a lifetime. Why? It is because the price of housing affects so many ordinary people so deeply. There will be no quick recovery from a collapse in housing prices, financially or psychologically. When stock market professionals recognize this, they will run for the door. If everyone runs at the same time, hardly anyone will be able to get out.
For the first time in 20 years, there is the possibility, though not a probability, of a market crash. All it takes is a catalyst, such as a news shock, that suddenly puts the whole picture in perspective. The most likely time for this to occur, if it does, will be before Nov. 1. If the market is trading near the same level next spring and the numbers in the housing market haven’t improved, the odds of a catastrophic decline go up astronomically.
If a major market decline does occur, don’t hold your breath for the bull market. A significant bounce almost always occurs after swift declines, but it will be just a temporary bull cycle within a now confirmed secular bear.
Lon Witter is a founding partner of Witter & Westlake Investments, a futures and equities market timing firm based in Louisville, Ky. He has been a market professional since 1976 and has been trading S&P stock market futures since their inception in 1982. He can be reached at email@example.com.