Double Bubble Trouble

February 2, 2008

January was certainly exciting. Investors finally removed their rose-colored glasses and collectively decided that the economy really is slowing and the housing market problems may be impacting several sectors, not just housing. In response, the S&P 500 fell just over 6%. 

We don’t know why the Dow soared to record highs in October amidst the deflation of one of the world’s largest asset bubbles in history. Nor can we explain why retailer’s stocks reached similar summits in 2007, especially given that a fair amount of consumer spending stemmed from ill-advised home equity extractions and the type of pseudo-confidence that occurs when you watch the value of your home, most likely your principal asset, double in just a few short years.

Until recently, many blamed the housing crisis on reckless subprime mortgages – home loans made to buyers with spotty credit histories. This risky practice would obviously affect financial companies, but shouldn’t matter much to the scores of prime borrowers who were still buying a fundamentally sound investment – their home.

We’ve written a great deal about the housing debacle over the past two years because we knew that it would ultimately take the economy and stock market down with it.

In some respects, this is how the early tech bubble troubles unfolded. At first, only the “stupid” dot com stocks like <i>pets.com</i> crashed and burned. But then tech stocks in general – including even legitimate businesses like Cisco, followed suit. Eventually, it became abundantly clear that growth stocks <b>as a whole</b>  were overpriced. Before all was said and done, most fell 50 - 90%. Many have never returned to their former glory. And somewhere along the way, experts stopped recommending growth stocks and moved on to less depressing opportunities.

Unlike the tech wreck, however, when the American Dream is the deflating bubble in question, election year politicians snap to attention. Exactly where were these public servants as recently as 2006, when <b>"no-money-down-interest-only"</b>  loans were being routinely made to shaky new home buyers? Today, as many as one in three of these loans is in default, and we're finally seeing some (expensive) action.

The government is mobilizing hundreds of billions of dollars in the form of unfocused checks in the mail, along with some incentives targeted directly at falling home prices – like raising the loan size limit for mortgages purchased by Fannie Mae and Freddie Mac. 

Soon, a prospective buyer of a $700,000 McMansion could benefit from lower interest rates with an unofficial guarantee that if the payments are missed, taxpayers will take care of any cash flow issues to the holder of said McMansion loan. 

Speaking of interest rates, the Federal Reserve shifted rate-cutting into overdrive in January, a move that will save tapped-out consumers tens of billions of dollars or more in interest costs on some types of mortgages and all the consumer credit (notably many credit cards) that is tied to the Prime Rate, which banks tends to drop in response to Fed rate cuts. Hopefully, consumers won’t simply borrow more and more as their monthly payments fall. 

Taken as a whole, this government aid (which even government help-haters seem to like) could be described as more of the same. More of the same stuff that played a role in home price speculations and inflation in the first place. As always, bubbles are created by people extending past performance to the moon, but this time the government also played a key role.

There are many government schemes in place intended to transform renters into buyers, but the two key ones are 1) tax deductions for mortgage and home equity interest up to $1.1 million in total loans, and 2) Fannie and Freddie programs that provide a sea of low-interest money to prospective homebuyers.

Somewhere along the way, the government simply stopped trying to help the poor find shelter, and began granting tax and interest rate breaks to the people buying second homes by the beach. The working poor were left with non-deductible rent and non-deductible credit card interest.

All of this good will was well-intentioned. Unfortunately, making borrowing cheaper and giving homebuyers more tax breaks can make their homes rise in price to the point that the benefits diminish. If we had higher interest rates on mortgages and no mortgage deduction today, home prices would be lower, because people could afford less home. Their monthly payments would be about the same – higher after-tax payments on a lower-priced home.

Of course, unwinding these perks now would cause a calamity of epic proportions. Without Fannie and Freddie or the mortgage deduction, home prices would fall about 50% nationwide. But adding more cheap money and tax break fuel to the fire is not a good long-term solution to the problem, either.

It's not that homes are bad investments in general (though historically they're not as good as stocks) and only slightly better than inflation. It's that homes, or any asset, for that matter, become bad investments if the price is too high.

Many of the stocks tied closest to the housing market – banks, REITs, and homebuilders – have fallen almost as low as they will go. Some will surely still go belly-up, but by and large, the 40% average dip in these stocks' prices reflects a new reality in housing. We intend to pick up funds in these areas on the way down – and have started with our highest -risk model portfolio. We're not sure where the exact bottom will be – probably either when people stop recommending these stocks, or after a few high-profile bankruptcies. If these sector funds lose 20% or more, we'll likely increase our stakes and bring them into safer portfolios, since risk drops as prices fall. The government is not going to let all the banks fail. 

The shoe that has yet to drop is the future of home prices themselves. Nationwide, they could still be due for another 20% drop, and some hot markets will fall another 40% - this on top of already steep markdowns from the artificially inflated prices of a few years ago. If we get a bout of high inflation, home prices may not fall as much.

U.S. stocks could be the best performing asset class overall in the next one to three years, even in light of the coming recession. The main reason for this tepid optimism is the lack of opportunity elsewhere. We were perfectly happy owning large investment-grade, short-term bond and cash stakes last year when the stock market was higher. But with the Fed hell-bent on taking interest rates down to around inflation or lower – and with lower stock prices – we’re not sure where else to go. 

U.S. stocks are growing increasingly out-of-favor with fund investors – who now prefer money markets in addition to their large foreign stock stakes. We're close to increasing our stock allocations across the board. We almost did a trade in January, when the market was down more than 11%, but its recent small recovery is keeping us on the sidelines for now.