Friday, December 17, 2004


The most recent housing report shows an unexpected 13% drop in housing starts! Is it possible that the housing boom is about to slow without an increase in mortgage rates? What if the housing market makes an upside down and backward move like we have never seen before?

For the past several years, market mavens have cried wolf numerous times in regard to the housing market. The housing market shrugged the cries off and more homes have been built in the past 5 years than any other five year period in the history of our country. In previous cycles we may have gotten to about the same peak level but this time we stayed at unusually high levels for a very long time.

Stock brokers, economist, market analyst and the public at large, myself included, have believed that eventually interest rates will rise enough to slow home construction. Numerous media reports have talked about the "housing bubble". However, in my Whoa! blog, I listed data that show that the dollar still needs to decline to reconcile our economy in relation to the rest of the world and, indeed, that long rates may be headed lower still. How can one reconcile the inherent conflict in having a strong economy and a strong bond market at the same time?

Well maybe, just maybe, we are about to see housing construction slow because we have simply built enough houses in America. After all, we passed the highest percentage level of home ownership we have ever seen in America some months ago. Government programs on the books for the past several years have allowed single persons and poor families to buy homes with no money down.

In my home town, there is hardly a street anywhere that does not have one or more houses for sale or for rent. Sales prices are going up steadily as families move to larger newer homes. On the other hand, small condos and apartments are not renting well. Some folks have left the apartments to move into starter homes. Some folks have bought the big new home while still waiting for their old home to sale but others are waiting to sell the old home before buying the new. Investors cannot buy the smaller rental houses or condos because the rents are not sufficient to cover the payments or costs.

In the 60's and especially the 70's, it was assumed that there was an unlimited demand to borrow money. However, under the current tax code, the tax incentives are gone in regard to credit card loans, car loans or other personal loans. The tax laws still encourage the purchase of a home or second home on borrowed money but little else.

Americans are not as dumb about finances as many pundits suggest. The numbers show that the public has taken full advantage of the tax laws. In the 70's, Americans borrowed at tax deductible rates that were below the inflation rate to buy cars and personal items. Now many citizens have paid off their high cost non-tax deductible credit card debt by refinancing and increasing the mortgage balance on their home.

Americans now have the highest debt to equity ratio on their home as they have ever had. However, they are in great financial condition. Americans now own over 56 Trillion Dollars of assets and they owe a total of less than 12 Trillion Dollars. Yes, Americans have a net worth of more than 44 Trillion Dollars. Their net worth is approximately five times their disposable income.

The numbers show that Americans are big earners and big spenders. Our economy makes most other economies look puny. For the past couple of years in particular, we have been the locomotive engine pulling the rest of the world economies along. Greenspan has raised US short interest rates the last 5 months in a row to try to avoid over-stimulating our economy. His actions should eventually almost force other world economies to do some of the pulling.

What if housing construction slows due to excess supply of homes?

Normally one of the reasons that long interest rates go up is because housing demand is also demand to borrow large sums of money. If the demand for houses is not there and if capital spending by business does not pick up the slack, then long rates may go down.

If US long rates go down, the dollar will likely also go down. In some instances American industries are becoming net exporters. For example, the chemical industry has switched from being a net importer to a net exporter. Dupont is just one of the strong companies that has made the switch to a net exporter.

If the US dollar declines further from here, US manufacturing will grow even more. For quite some time, the transportation index has been forecasting a very strong US manufacturing economy ahead. Many months ago, I wrote about the tight capacity at CSX railroad and at Yellow Freight. The merger of Yellow and Roadway was over a year ago. NSC made an all time high a couple of weeks back. A few weeks ago, I wrote about General Electric. I said to invest in the "big, dumb and ugly" American companies. Since then, GE is up in price maybe 8% and has announced a 10% dividend increase and a 15 Billion Dollar stock buyback. Two years ago, K-Mart was bankrupt but this year its real estate value was of such value that the company was able to use its shares as currency to buy Sears!

I don't remember all the details but some weeks ago, Ken Fisher wrote a piece titled something like "The Great Melt UP!" In the piece he suggested that the stock market is going to surprise almost everyone in just how strong a move we experience. Ken is one of those guys who is right most of the time.

A fact that seems to be under appreciated is that under the after tax return under the current tax law a dollar earned from a stock is often worth $2 earned from a bond. Bush has stated his high priority of making a dollar earned from a stock a tax free dollar. What is happening is a fundamental realignment that happens only about once or twice in a lifetime.

I can't blame Jimmy Carter for the hyper inflation of the late 70's. Until the tax laws were reformed, the public was being paid to borrow money. The Bush tax law change means that the public is getting paid double to own stocks. A fundamental law is that if you increase the after tax return for an investment, the demand for that investment is going to go up and the price will also go up.

The Chairman of E-Trade was on CNBC Thursday evening. Schwab and E-Trade have each announced trading activity increases of about 23%. The crazy trading in SIRI was about 2% of that increase (I plan to sell the rest of my families SIRI this morning). The relevant point is that the public is just now seriously returning to the market.

When the public returns after a long tough period of time, it marks the beginning of the end of the bull run. Those who are not in the market now should get in quickly because the next leg will probably last months but not years before the next 15% correction.

I have often posted the John Kenneth Gailbreth quote that, "In economics the majority is always wrong". Our egos get in the way and it is easy to believe that we and a few people we read are smart and everyone else is wrong. However, the current jigsaw puzzle has bothered me for a time because all the pieces did not fit.

But, clearly, the majority of Americans believe that interest rates are likely to rise in 2005. Therefore, since "the majority is always wrong", interest rates will actually decline. The dollar will decline and the US stock market will remain very strong for several months to come. This scenario fits with many other pieces; such as the high levels of outflows to foreign mutual funds and small cap mutual funds and the super strong transportation index.

Another interesting way the puzzle all fits together relates to health care stocks and developing nation stocks. The recent bounce in health care stocks means that this group has out-performed the other 7 S&P sectors for a whole month. From earlier blogs, you know that I believe health care will do well in the second phase of the economic growth cycle. You also know that the Brazil and other foreign ETFs have had outstanding performance for several years. The entire Brazil market is up about 4 times and guess what country was just recommended in businesses week. (Business is a great business magazine but it reflects popular sentiment like TV and other media, it only highlights a trend near the end of the trend.)

Anyway, Heath Care is showing strong relative performance and Health Care stocks only have a 34% correlation coefficient with foreign stocks. Technology stocks have a 62% correlation coefficient to emerging market stocks and a 42% correlation to Health Care.

Another piece that fits well is that the correlation coefficient between small stocks and large cap value stocks are respectively 55 and 69%. Growth and Technology are tight with an 84% correlation.

My bottom line is that I will continue to move into big cap, value, US companies. I will trade out of pure technology manufacturing semiconductor type companies. Although GOOG, EBAY, YAHO, AMZN and others use advanced technology, I do not consider them to be technology companies. They certainly are growth companies but I believe the value is there also. I will also continue to hold companies like Dell and IBM. Both these companies receive significant revenues from service contracts and Dell merely assembles high tech parts that are mostly manufactured by others. It is a marketing company.

In a bull market, if one invests in 15 or more stocks, one is almost assured one will make good money. However, markets do rotate from sector to sector. Energy just had a great one year run. Consumer Staples and Health Care are showing leadership now (Clorox was the latest consumer staple company to announce excellent results). Most Health Care stocks have had a horrible year until just recently. Semiconductors were strong early in the year and died later.

The point is that now is the time to evaluate what you have and adjust accordingly. I would be pleased if you would allow me to comment on your specific holdings.

NO! I do not plan to buy bonds any time soon. I plan to continue to invest aggressively in the US stock


Jack's Old Merrill Pal said...

Interesting observation. Yes home ownership is at an alltime high which is a good thing. As I pointed out earler, the US consumer does not get credit for the massive amounts of capital invested into their homes. Just as an aside, my father-in-law tells me their were only about 20 private residences in Dusseldorf, Germany roughly 10-12 years ago. Everyone rents!

My real point to this blog is the fascinating quandry (there is a word the average Gen X'er never hears)the overseas Treasury managers and investor faces. They are faced with large amounts of US dollars due to our indulgence. They do not receive these dollars and place them in piggy banks. I just figured that one out. Quite often they invest in US Treasurys and other securities.

For example the Chinese have and increase large positions in the US Treasury. Simply put these are some of their choices with their cash:
1) Add to US Treasury positions
2) Diversify to other US securities
3) US Real Estate
4) The piggy bank

I would agree with the Doctor the large US foreign account balance holders will pursue US Securities ie the Big, Dumb and Ugly. They are in a catch-22 with the Treasuries due to the fact that rising interest rates will diminish their current portfolio value, a dollar rise notwithstanding. Nevertheless I believe venturesome foreign debt holders will indeed move in that direction.

Does this current situation not appear similar to the mid-late 80's when the Japanese were going to own the world. They bought everything all types of US assets eg Pebble Beach. Of course eventually the Japanese had to sell many of these assets due to internal structural problems in Japan's economy.

Doctor, do you have a long term ( over 10 years ) DJIA chart?