Does Leverage Matter?
This has been a quiet week, especially compared to last week's deluge of economic data. Earnings preannouncements and a few earnings reports attempted to keep investors attention ahead of next week's FOMC meeting. By early indications, second quarter earnings should continue to be strong. For the first time that I can remember more companies are guiding earnings higher rather than lower. There have been 91 companies that have said earnings would be greater than analysts' forecasts compared to 73 that have guided analysts to lower earnings projections for the second quarter. This of course leads analysts to increase their earnings estimates. Second quarter earnings growth estimates for the S&P 500 have increased to 20.3% from 19.0% at the beginning of the month and 13.6% at the beginning of the year. The sector with the greatest increase in earnings estimates is the energy sector. Earnings growth estimates for the energy sector have increased to 41% from 31% at the beginning of the month and just 8% at the beginning of May. Currently, analysts do not expect energy companies to sustain their current rate of earnings growth. Earnings growth for energy companies is forecasted to decelerate to 14% in the third quarter and to 12% in the fourth quarter.
FedEx reported that fiscal fourth-quarter earnings jumped 47% and package volume increased 7%. International priority shipments increased 7% with most of the growth coming from Asia. Shipments from China increased by 18% and U.S. domestic volume increased 2%. This was the largest gain in three years. Costs escalated during the quarter, with fuel costs rising 17% compared to last year. The number of packages sent via FedEx ground jumped 12%. FedEx also expects to increase its capital spending in fiscal 2005 to $1.6 billion from $1.3 billion last year. The company also increased its earnings guidance for the current quarter and fiscal year.
Last week, Richard Bernstein, Chief U.S. Strategist at Merrill Lynch, issued a report that added another plank in the housing bubble debate. Bernstein thinks there is a housing bubble in the United States based on five factors that he believes defines asset bubbles. These factors are:
- Available liquidity.
- Increased use of leverage.
- Democratization of the market.
- Increased turnover.
- Increased new issuance.
It is easy to conclude that based on anecdotal evidence along with economic data that each of these conditions exist in the current housing market. Bernstein's latest report focuses on the returns that homeowners have seen over that past couple years. He contends that homeowners have enjoyed much larger returns than the simple appreciation of their house. Since virtually every homebuyer finances the overwhelming majority of the purchase, the returns "earned" on the homeowners invested capital are substantially larger. He showed what the "cash-on-cash" returns have been for homeowners over the past twenty years and starting in the mid-1990s the "cash-on-cash" returns began to depart from the actual home price appreciation. The increased leverage associated with historic low levels of homeowner's equity has caused the "cash-on-cash" return to increase faster than the underlying home prices. Just using the average percent of equity home ownership as the amount of leverage leads to "cash-on-cash" returns that are about twice as great as the underlying house appreciation. New homeowners are even more leveraged as they typically have twenty percent or less of equity. Assuming 20% equity, the "cash-on-cash" return is five times the home's price appreciation. Unfortunately, leverage runs both ways. It is not uncommon to find homebuyers putting 10% or less down on a house. This means that a 10% decline in the price of the house reduces the homeowner's equity to zero. Additionally, with the increased amount of cash-out refinancing and home equity loans in recent years, there are probably a substantial number of homeowners with less than 10% equity.
Bernstein also noted that in discussions with Washington economists, they had not considered the increase in the use of leverage in assessing that there was not a housing bubble. He also said that they had not thought about the effect of "cash-on-cash" returns that homeowners have enjoyed. That certainly was the case based on a paper published by the Federal Reserve Bank of New York, Are Home Prices the Next 'Bubble'?. The authors use the following as the definition of an asset bubble:
If the reason the price is high today is only because investors believe that the selling price will be high tomorrow - when "fundamental" factors do not seem to justify such a price - then a bubble exists (p. 13). - Stiglitz, Joseph E. 1990. "Symposium on Bubbles." Journal of Economic Perspectives 4, no. 2 (spring): 13-8
The study basically pointed to increasing incomes and the decline in interest rates as the fundamentals that support higher housing prices. There are several areas that were left unaddressed. First and foremost, there was no discussion about what would happen when interest rates start to tick back up. We have proposed that housing prices have behaved similar to the price of a bond. We view monthly payments being the leading factor in determining how expensive of a house the buyer is can purchase. As interest rates rise, the amount homeowners can afford each month will stay the same, or might even decline if other debts are variable. If housing is being priced based on the monthly payment, price will surely have to decline. The only discussion regarding the increase in leverage by homeowners was in relegated to one footnote. Lastly, the increased activity in housing and mortgage finance has likely created jobs. In fact, of the 690,000 jobs that have been added from May 2003 to May 2004, almost 40% have been in the construction or real estate sector. Additionally, as Doug Noland has pointed out, income growth has likely been bolstered as well.
The current market environment is not investor friendly. There are several crosscurrents that have investors sitting on their hands. Bears note that earnings comparisons for the second half of the year are going to be tougher and rising interest rates will substantially slow the economy. Bulls point to the strong economic data and corporate earnings. Both camps are wary of the events next week, the turnover of power in Iraq and the FOMC meeting. While it is impossible to predict if conditions will get worse after the turnover of power, it adds another level of uncertainty that compounds all the uncertainty already in the market.