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July 28, 2006

Housing Bubble, Recession, and That 70s Show
by Emanuel Balarie

This past January, I wrote an article titled "Real Estate Burst, Upcoming Recession, and Soaring Commodity Prices". At the time of the article, most people thought that a recession prediction was outrageous and that a burst in the real estate market was hopelessly pessimistic. Since then, we have seen clear signs of an upcoming recession as well as a slowdown in housing that is only set to accelerate. Recently, I have had a number of inquiries from readers that wanted some updated information on the above mentioned article. If you have not read it, I urge you to read it here:

While the Federal Reserve and most Wall Street economists continue to predict a soft landing scenario in housing, the increasingly worrisome economic data tell another story. In fact, if one were to compare shopping for a house today with shopping for a house in January, one would see some noticeable differences.

Are you worried about having someone outbid you? Don't worry. Houses are on the market a lot longer (approximately 6 months) and inventory is at a multi-year high. The National Association of Realtors reported this past week that the number of homes for sale is at their highest point since 1997. The Commerce Department also reported today that new home sales dropped by 3% last month.

Is your Real Estate agent telling you that you better buy now before prices go even higher? Don't believe it. Housing prices have already started their decline. Take a look at the recent decline in San Diego County Media Home Prices.

Source: http://piggington.com

The sharp decline over the last couple of months does not look anything like a soft landing scenario.

Did you plan on paying for your closing costs? No need. Sellers are paying for closing costs and even offering new washer and dryers to boot! Home builders are even offering incentives for upgrades and even leases on luxury cars.

It is clear to me that we are well on our way towards the housing burst that I predicted in January. Anecdotes about housing incentives will only multiply; supply of homes on the markets will increase, and prices will continue falling.

Foreclosures

According to Foreclosure.com, foreclosures are up 2.6% throughout the country. While this number does not seem staggering, it does reaffirm a change in the trend. In fact, some areas of the country are already showing a dramatic increase in foreclosures. In Dallas, for example, foreclosure rates are up 26%. As interest rates continue rising and the overextended homeowner is faced with the reality of higher mortgage payments, I expect that we will see these numbers exponentially rise.

Going Forward

At the center of the housing burst, is the continual and inevitable rise in interest rates. While most Wall Street economists firmly believe that the interest rate hike is over, I contend that this outlook is undeniably shortsighted. In fact, most of these economists that are predicting a pause or a stop in rates have had this outlook for the last several rate hikes. Generally speaking, their argument is centered on the fact that they feel that inflation is not a problem.

Inflation, however, is a problem. Over the last several years we have seen the price of oil triple and raw material costs reach multiyear highs. While manufacturers and producers have been eating up these costs for the last several years, this trend is not likely to continue. In fact, we are already starting to see companies pass through the high energy costs to the consumers. Companies like FedEx have raised their prices due to higher energy costs. Even some restaurants are beginning to pass through the higher transportation costs to the consumer. The end result of the pass through of costs is a higher core CPI number.

The significance of higher core inflation is that the Fed will finally be forced to acknowledge inflation. Ben Bernanke has clearly stated that they will rely on data to determine their actions. Rising inflation would force the Fed to continue moving rates higher. The last several months have resulted in higher than anticipated core CPI numbers. In March, the core CPI jumped up 0.3%. Wall Street economists had expected a 0.2% increase. In April, the core CPI jumped up another 0.3%. This number again came in above Wall Street expectations of 0.2%. May once again showed another 0.3% increase in the core CPI numbers. Not surprisingly, Wall Street had expected an increase of .2%. Finally, the June CPI numbers also came in at a 0.3% increase, higher than the expected 0.2% increase. The Fed continues to argue that inflation is contained, yet I believe that the cat is already out of the bag. Going forward, I expect further spikes in the core CPI numbers to translate into higher interest rates.

The rising interest rate environment will have a negative impact on homeowners who have interest only or adjustable rate mortgages. In the next 18 months, there will be approximately 2 trillion dollars worth of adjustable rate mortgages that will have to adjust to a fixed rate. Overextended homeowners who were paying a certain amount on their mortgage will be forced to pay a higher rate. Unfortunately, a good number of these homeowners do not have the means (see negative savings article) to afford the higher mortgage payments. With rising interest rates, we will see a rise in foreclosures, which lead to additional supply of homes on the market. The additional homes on the markets coupled with slowing demand will translate into a continued burst in the Real Estate Market.

Recession

Recessionary concerns have also intensified over the last six months. Whereas several months ago few people were arguing the recession scenario, there are now more people that are at least acknowledging a slight probability of an upcoming recession. In truth, there is more than just a slight probability of an upcoming recession. If you subscribe to a burst (or even slowdown) in housing, you should expect a recession to unfold.

As real estate prices have climbed in the last several years, we have seen consumer spending go through the roof. In turn, this has led to strong corporate profits and a false sense that we have a strong economy. However, borrowed money does not translate into a strong economy. It only translates into an eventual recession. Take a look at the below chart. It tracks consumer spending versus housing.

As you can see when housing slows, the consumer stops spending. Of course, this makes sense. Consumers will no longer be able to tap into their home equity and withdraw cash for frivolous expenditures. In addition, those that will be able to remain in their homes will be forced to pay more on their home mortgage. It is important to note, that if we were a manufacturing economy, this would not hold as great of significance. However, we are a consumer led economy. As a result, a slowdown in consumer spending will be put a screeching halt to this pseudo-economic growth we have experienced in the last several years.

A housing burst will also contribute to a higher unemployment rate. While it is true that the current unemployment rate is pretty low, I do not expect this trend to continue.

Mortgage companies, real estate firms, construction companies, and other real estate driven industries will be forced to lay off workers as the real estate bubble comes to an end. Additionally, industries that rely heavily on discretionary consumer spending will also lay off workers. Already, we are starting to see signs of a slowdown in consumer confidence and spending.

Are We Watching Re-runs of That 70's Show?

While the upcoming real estate and economic outlooks are far from rosy, you can position yourself to weather out this storm. Fortunately, we can look at the past as a point of reference of what might happen in the future. During the 1970's, Americans experienced high inflation, a recession, and rising interest rates. Sound familiar? The 1970's also provided investors with an opportunity to profit in commodity markets.

Gold, for example, moved up 19.5 times in value. At the end of 1971, Gold prices were trading at just about $43/ounce. Before the bull market was over, Gold prices had reached a high of $850 an ounce. In comparison, the present bull market in gold has only appreciated 2.5 times in value. Although there were some 1970-specific factors (such as the end of the gold standard and the oil embargo) that are absent from today's market, the main factors that were present during the 1970's are clearly present today. One can also argue that there could potentially be a greater demand for gold during this bull market. Population growth and wealth creation in Asia, central bank buying, and a declining interest in fiat currencies are just a few reasons why this could be the case.

Besides gold, there were other commodities that experienced appreciation during the 1970's. Sugar went up 9 times in value. Coffee went up approximately 6 times in value. All in all, commodities were in a bull market.

At the present, there is speculation that a rising rate environment could put an end to rising commodity markets. Some pundits argue that higher interest rates will slow down economies, which will in turn slowdown demand for commodities. This logic, however, is flawed. First, we have had 17 consecutive rate hikes. During the rate hikes we have seen commodity prices continue to soar. Second, the 1970's clearly showed us that commodity prices can still rise as interest rates rise. Take a look at the below chart:

Source: www.yardeni.com
Courtesy: Puru Saxena's Money Matters, www.purusaxena.com

There are clearly investment opportunities during the upcoming recession and housing burst. You can either continue to believe that the economy is strong and that we will only have a soft landing in housing, or you can start positioning yourself to deal with the upcoming recession and housing burst.

Other Strategies

While many investors are well informed on stocks and bonds, few have diversified with portfolios with managed futures. Managed futures may provide above average returns in both bull and bear markets. Having a buy and hold stock portfolio might not necessarily make sense for all investors. If you are interested in learning more about managed futures or would like to sign up for my free commodity newsletter, please sign up here:

The risk of loss in trading commodity futures contracts can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition.

Emanuel Balarie
CommodityNewsCenter.com

Emanuel Balarie is the Editor of Commodity News Center and the author of the highly acclaimed book, Commodities For Every Portfolio: How You Can Profit From The Long-Term Commodity Boom.

Mr. Balarie's industry experience ranges from commodity stocks to futures to alternative investments. He is a highly regarded advisor to clients and institutions on the commodity markets and managed futures investments, and has had his research published all over the world. In addition to his several CNBC appearences, Balarie is frequently quoted in financial publications such as The Wall Street Journal, Reuters, Marketwatch and Barron's.

Mr. Balarie was one of the few market strategist to correctly predict this multi-year bull market in commodities, the decline in the US dollar, and the downturn in housing.

The risk of loss in trading commodity futures contracts can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition.

Copyright © 2005-2008 Emanuel Balarie

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