Housing: The New Stock Market?

A great sigh of relief went up on Wall Street Wednesday as stock proxies recovered from a midday swoon to end with decent gains.

After having traded as high as 8723.37 early in the session and as low as 8452.76 around 1 p.m. EDT, the Dow Jones Industrial Average closed up 0.8% to 8542.48, snapping its losing streak at seven. The S&P 500 rose 0.6% to 906.04 vs. its earlier high of 926.52 and low of 895.03 while the Nasdaq Composite gained 1.6% to 1397.25 vs. its morning best of 1426.28 and nadir of 1370.21.

The markets swung higher in the last hour of the session and market players moved on quickly after the bell to the news from IBM (IBM Quote), among others. Big Blue posted earnings that were slightly better than expected, but down dramatically from year-ago levels.

The markets' machinations notwithstanding, I found my attention drawn by the discussion of the housing "bubble" before Congress today.

House Music All Night Long

Fed Chairman Alan Greenspan is quite certain there is no housing bubble.

"The type of underlying conditions that create bubbles are very difficult to initiate in the housing market," Greenspan said, during the Q&A following day two of his semiannual monetary report to Congress. "It is not an issue on the table on the moment."

Well, we hate to disagree with the chairman, but whether or not housing is a bubble is certainly a prominent issue on the table in many American kitchens today.

Greenspan's comments came after the government reported a 3.6% drop in housing starts for June, which was slightly larger than expected but followed robust gains in May and for the past year-plus. Indeed, few would argue that the housing market isn't currently strong. Concurrent with the housing starts decline, building permits rose 1.4% last month, suggesting housing will remain solid for the foreseeable future. Today's better-than-expected earnings report from homebuilder Centex (CTX Quote) was another indicator of housing's health.

The question is whether housing is too strong, aka, a bubble.

Faithful readers will recall back on Feb. 28 (before it was fashionable) I wrote about the housing bubble debate. At the time, I suggested the question was not if housing was in a bubble, but at what stage it was at, i.e., comparable to tech stocks in 1996, before their biggest gains, or in 1999, just before the peak. (I re-examined that analogy on March 22, pointing out that I wasn't making a direct comparison, as many readers presumed.)

Since Feb. 28, the S&P Housing Index is down about 9% after rising fractionally today, roughly half the S&P's decline. Recent action in heretofore relatively strong stocks suggests the sector remains dicey. Furthermore, today's near 40% drop in Capital One Financial (COF Quote) shows how vulnerable housing and related stocks could (could) be if the market decides those sectors are similarly overexposed to overleveraged consumers. That risk is obviously greater in mortgage lenders, but homebuilders would be indirectly affected, especially those engaged in lending activities such as CTX, which rose 0.4% today.

On the other hand, Banc of America's Carl Reichardt raised ratings on D.R. Horton (DHI Quote), Lennar (LEN Quote) and Toll Brothers (TOL Quote) earlier this week, suggesting "valuations have gotten cheaper" because of the recent selloff, "while the potential for earnings growth in 2002 and 2003 has gotten greater."

Paul Kasriel, chief U.S. economist at Northern Trust in Chicago, recently examined the capitalized value of implicit rents on homes and found they were "on the low side, but historically not out of line with the historic value of housing."

[UCLA professor Edward Leamer has created a similar metric that calculates the "price/earnings" ratio of a home -- with the earnings portion of the ratio being the home's potential rental income. The Wall Street Journal recently reported Leamer found housing P/Es were high in areas like Seattle and San Francisco, but relatively low in areas like Dallas and New York. Today, Greenspan reiterated the point he'd made in mid-April -- that diversity of local real estate markets and high transaction costs make a national housing bubble unlikely.]

Noting those figures, low interest rates and that "tax laws encourage people to go into housing," Kasriel doubted that housing is in a bubble mode. Then again, "people now seem to be obsessed now with housing and housing values just as they were obsessed with stocks a few years ago," the economist said. (Of course, much of housing's recent appeal to investors is as an alternative to equities.)

The real concern, he surmised, is that housing is a "highly leveraged" market. If interest/mortgage rates were to rise, "there's a higher probability people will default on mortgages," Kasriel said, especially if higher interest rates are accompanied by higher unemployment.

"If some lose jobs, regardless of rates they may not be able to make mortgage payments." (The economist has long warned about a potential re-emergence for these kind of stagflationary pressures, as has this column.)

According to the Fed's flow of funds data for the first quarter, U.S. households debt to income was 105.9% in the first quarter. Kasriel prefers to measure total liabilities relative to assets, which was 16.9% in the first quarter vs. a record of 17.1% in the third quarter of 2001. Given the decline in asset values (read: stocks), he believes a new record will be set when the second-quarter data are released.

No Friend of Alan

Although Kasriel agrees with the chairman's assessment of the current state of housing, he disagrees with Greenspan's contention that rising consumer debt levels aren't worrisome. "Mortgage debt has not been going up faster than the rise in the market value of homes," Greenspan said today.

But "given Greenspan's track record on spotting bubbles and just about everything else, I don't know why we should really care what he says about housing," Kasriel retorted.

The real concern shared by Kasriel, this column and others is that Greenspan & Co. have gambled that by keeping interest rates at historic low levels, consumers will keep borrowing and spending, keeping the economy afloat until business spending revives.

The problem with that is borrowing "to buy bigger houses, SUVs and cruise missiles" does not increase productivity, Kasriel quipped. "Bubble or not, the fact we're investing so heavily in housing is not adding to our productivity" and doesn't help us repay the $1.25 billion current account deficit that foreigners fund daily -- with increasing reluctance.

"The Fed was an enabler of this whole [financial] bubble by creating cheap credit and now they're trying to keep things going by allowing households to borrow at low rates," Kasriel said. "Ultimately we're putting off judgment day. When the Fed finally has to tighten because of a run on the dollar or inflation moving up, then it's going to be interesting."

Indeed it will, considering consumer spending is the proverbial "last shoe" and housing is currently the lace holding it together.

P.S.

Hopefully that day won't come anytime soon and the market will remain (relatively) calm as I'm off until Monday. I'll be traveling to attend some family gatherings, which thankfully are of the "happy" variety.