Here is what Shiller said upon the index's release:
"Year-over-year and monthly price returns are continuing to either move deeper into negative territory or are experiencing persistent diminishing returns. There is really no positive news in today's report, as most of the metro areas are showing declining or vanishing returns on both an annual and monthly basis."

Meanwhile, the National Association of Realtors recently reported that September's existing-home sales fell by a surprisingly large 8%, accelerating sharply from August's 4.3% drop. This indicates that the Case-Shiller Index will likely exhibit a sharp drop for September.

Downturn Seems Likely

The case for a protracted housing downturn (until 2010 at the earliest) and a broad and associated negative wealth effect remains strong.

  • Home affordability remains stretched. Home prices in real terms are only about 3.5% lower than at the peak last year. According to Dr. Lacy Hunt, "Real home prices remain nearly 58% above the previous cyclical high reached in 1989 and almost 94% above the average real price from 1890 through 2007."
  • Housing starts would have to drop by another 25% just to reach the average cyclical lows over the last 50 years.
  • We are now at a record level of months of unsold home inventory. With cancellations as high as 50% to 65% at certain public homebuilders, resets accelerating into next year (causing more defaults/foreclosures and supply to come on to the markets) and with lower selling prices and concessions failing to stimulate demand recently, unsold inventory will likely expand in the months ahead.
  • Not only has the issue of home affordability yet to be resolved, the cost of home ownership is still high relative to rentals. According to Dr. Shiller, home prices would have to fall by more than 50% to be aligned with rental values.

Consumer Stretched Ever Further

Further exacerbating the problem is a levered consumer.

  • Surprisingly, the consumer has not deleveraged; he has become even more leveraged -- despite the housing mess. Over the past six years, more than $1.1 trillion in mortgage equity withdrawals have been made, representing 45% of the total increase in consumer spending (PCE) in that period. The trend in the first half of 2007 continued apace, with cash-outs equal to 50% of spending.

    The abrupt tightening in credit standards, wich began midyear as the subprime problem mounted, suggests that the housing ATM will not provide the injection of capital for the consumer over the balance of 2007 and into 2008-09.
  • Household mortgage debt has risen by 135% ($10.1 trillion) over the last eight years. During that period, incomes have materially lagged, causing mortgage debt as a percentage of disposable personal income to rise from 64.5% in 1999 to over 100% in 2007. Shockingly, the ramp from 64.5% to 100% represents a rise greater than in the 45 years leading up to 1999.
  • Total household debt, adding in credit card and installment debt to mortgage debt, looks as worrisome as it has risen (as a percentage of disposable personal income) from 93.5% in 1999 to 131.3% currently.
Bulls argue that U.S. corporations' financial health has never been better and might offset the consumer's plight. I am less certain, as nonfinancial corporate debt as a percent of GDP has risen steadily higher over the last two years. It now stands at 43.7% compared with 41.5% two years ago. During the last 55 years, corporate debt has averaged only about 34%, well below today's figure.

A further cut today in the fed funds rate will modestly reduce the interest rate burden relative to profits in the corporate sector and income in the consumer sector, but its relative effect will be muted by the pressure of moderating corporate profits and personal incomes in a maturing domestic economy. For the massive group of homeowners facing massive resets, however, there will be little benefit at all.

Despite today's expected easing, I remain more convinced than ever that retail spending, which has steadily weakened in the last six months, is going to decline more precipitously in the months ahead -- and so, too, will the expectations for economic and corporate profit growth drop.

Maybe one day even the stock market will drop in response to these lowered expectations.
At the time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.

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