First the stock market soared to new all-time highs. Then came the word that home prices had just posted their first double-digit annual gain since 2006. Are the boom times back for stocks and real estate?
Certainly, recent gains are a sign of hope, but with every bull market comes a fair amount of hype as well. Before you plunge head-first into volatile markets, consider the following reasons to be a little skeptical about these recent market rallies.
1. The economy is still built on a mountain of debt
While recent years have seen a decline in mortgage debt outstanding, they've also seen an increase in other forms of consumer debt, from car loans to credit card debt. An over-reliance on debt is a very perilous basis for an economic recovery, so until the earnings of Americans actually start rising, it will be hard to believe that the rallies in stocks and real estate have true staying power. Also, note that even though interest rates have fallen, Americans have traded some of the lowest-cost debt (mortgages) for more expensive forms of consumer credit.
2. Unnaturally low mortgage rates are supporting the housing market
Recently, 30-year mortgage rates were about 3.5 percent. That's close to their all-time low, and much lower than they've typically been historically. What would happen to the rally in housing if mortgage rates were to rise to more normal levels? Well, people tend to decide how much house they can buy based on the monthly payment. At a 3.5 percent mortgage rate, a $200,000 house will cost you a monthly mortgage payment of just under $900. At 6 percent, you could only afford a $150,000 house on the same payment.That implies that if mortgage rates were to rise to 6 percent -- which is still on the low side historically -- home prices would have to drop by 25 percent to compensate. Such a drop can be avoided, but only if demand picks up sufficiently to make up for higher mortgage rates. Either way, rising mortgage rates are likely to be a heavy drag on home prices going forward.