Home Is Where the Investor's Heart Is

First, the (mildly) good news: There is little doubt among economists that the world experienced a synchronized global recovery in the first quarter of 2002, following the cyclical downturn of 2001. That's what you would expect in the wake of 200 central bank easings around the globe. In the past two weeks, governments have reported that U.S. employment has precariously stabilized, German real manufacturing orders have turned up, and Tokyo consumer confidence has turned up.

The problem is that the recovery is stalling, if it hasn't halted. According to economists at International Strategy and Investment (ISI), industrial production in this recovery is off to the slowest start of any recovery in the past four decades, possibly because the recession that preceded it was relatively modest in real terms (e.g., units sold), though it was harsh in nominal terms (units plus price). In 1971, industrial production was up 8.2% in the first five months of recovery from recession; in 1975, +10.7%; in 1983, +8.2%; in 1991, +6.2%. In 2002, industrial production is up just 3.4% -- half the previous slowest rate.

ISI researchers believe that weekly economic numbers will continue to indicate a second-quarter stall, but that by midsummer they should point to a reacceleration in the third quarter. For now, they're giving mixed signals:

Bears will note that ISI's weekly surveys of current sales results at retailers, auto dealers, manufacturers, homebuilders, banks, technology companies and airlines suggest the recovery has softened; that the Economic Cycle Research Institute's weekly leading indicator has hiccupped; and that First Call's tally of upward analyst earnings estimates has flattened.

Bulls, in contrast, will point out three signs of strength: Commodity prices are still rising, signaling demand; consumer confidence is strengthening; and the nation's money supply is beginning to reaccelerate.

Each side has plenty of additional ammo that it can lob at the other camp. One of the most persuasive arguments for the bears, according to ISI, is that economic activity has been artificially lifted in recent months by at least seven positive effects that are now ebbing: Tax rebates, a post-9/11 "defiance" rebound, 0% auto financing, home mortgage refinancing, warm weather coupled with low oil prices, tax cuts and tax refunds.

A spare bullet for the bulls is evidence that the manufacturing sector is still gaining strength. Although the latest comparable-store sales reports show that consumer spending at broadline and specialty retailers faltered in May, the latest figures from the Institute of Supply Management show that manufacturing orders continue to turn up. ISI says its company surveys suggest that trucking and chemical suppliers are particularly strong, while capital goods suppliers, such as tractor makers and tool manufacturers, are weaker.

No Real Estate Bubble -- Yet

All of this uncertainty, combined with accelerating fears that the stock market game is completely crooked, has fueled the ongoing boom in home prices across America as investors shift more new funds into real estate rather than stocks. ISI has compiled a list of seven reasons why individuals are finding real estate more attractive than stocks:

Home prices keep going up at the same time that prospects for alternatives (stocks, bonds and cash) appear increasingly poor.

Individuals are increasingly viewing an investment in housing as a fourth asset class, after cash, bonds and stocks.

Housing has several unique characteristics as an investment: Prices are seen as always rising, given a long enough time horizon, mortgage interest is deductible, capital gains taxes are limited, refinancing is a cinch, there are no margin calls, the leverage potential is huge, you can live in a house if all else fails, and they're more fun to look at than a 401(k).

Financing is incredibly easy, and Fannie Mae provides a virtually unlimited source of funds, at least for now.

The demand scenario for housing is favorable, as immigration, a rising birth rate and second homes fuel interest at a time when supply is limited in the best locales.

If inflation slows in 2002, as it typically does after a recession, bond yields, and thus mortgage rates, will probably decline -- fueling a strong market for housing into 2003.

Home prices are heating up around the world, particularly in Europe.

Many observers have contended that the U.S. real estate market is in a bubble that will burst as soon as stocks come back. But housing prices in the U.S. are nothing compared with those in the U.K., where the ratio between average home price and income has soared to 8:1, vs. just 3:1 here.

ISI economists believe that U.S. home prices are not in a bubble now but could enter one in 2003, pointing out that residential investment as a percentage of disposable personal income currently is at 6.1% -- a figure that's up from a low of around 4% in 1990, but well off the 9% level seen in 1955, the 8% level of the 1970s or the 6.8% level of the mid-1980s.

The distinction between rates of return in the overall economy vs. real estate has led to the most dramatic distinction of all between the housing market and all other industries: Banks have been increasing their loan exposure to real estate at an ever-increasing rate since 1999, while at the same time steadily cutting back on their commercial and industrial loans. Bank C&I loans, as they're known, have slowed to around $1 trillion outstanding from their peak at the start of 2001.

Home Improvement

How to take advantage of this trend via stocks, presuming you are one of the two-thirds of Americans who already owns a house or two?

Since June of last year, our StockScouter rating system has been high on the shares of homebuilders, regional banks and thrifts (which lend to homebuyers), real estate investment trusts and the manufacturers of peripheral items such as carpets and couches and lawn mowers. A 10-stock June 2001 portfolio created using Scouter metrics is up 26% -- almost exactly the reverse of the 26.6% decline in the S&P 500 over that time. Likewise for Scouter's 10-stock July 2001 portfolio (+19%), which included three thrift or regional bank stocks; as well as portfolios for every month since.

The current list of top-ranked StockScouter choices continues to include several housing-related stocks. A handful to consider, all rated 9 or higher on a scale of 1 to 10, are listed in the table below. I will track these shares over the next year and report back periodically.

StockScouter's Housing Picks
Company	Ticker	6/6/02 price	P/E ratio
Countrywide Credit Industries	CCR	$47.55	11.3
Hudson United Bancorp	HU	30.24	12.2
Annaly Mortgage Management	NLY	19.41	7.9
Deltic Timber	DEL	31.20	n/a
M/I Schottenstein Homes	MHO	65.84	8.6
Apex Mortgage Capital	AXM	14.61	5.1
Cathay Bancorp	CATY	40.88	16.6
First BanCorp	FBP	34.30	12.5

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