Monday, March 24, 2008


There are many differences between the current financial mess and those of the past. This morning I would like to focus on one of the differences in regard to the housing market.

In the housing crunches going back through the 1980's, mortgage interest rates were no where near current rates. In the biggest crunch, the one in 1980, home sales declined about 28%, housing starts fell about 50% and home prices fell about 7%. Mortgage rates were still on the way up at the worst of this crunch, rising from around 15% in 1980 to 18.5% in mid 1982! During the current crunch, we have seen sales fall about 25%, home starts fall about 40% and prices fall about 10%, but the big decline have been concentrated in luxury second home markets and while mortgage rates bounced as high as 6.75% after the lows of 2003, they have since returned to the historic low area of 5.6%!

The payments on a $200,000 loan at 15% in 1980 would have been $2,529. Eighteen months later, the payments on the same loan reached $3,096. The 30 year fixed rate payment today would be $1,148. The same loan would cost $1,948 less than in 1982! Today, there are variable rate options with starter rates of 4.25% locked in for two years with a maximum increase of 1% after two years and a maximum possible rate of 9.25% over the life of the loan. At the starter rate, the payment on $200,000 would be $983 or 68% off the price of 1982. It is probable that the money saved at 4.25% and 5.25% for the first 4 years of this loan would forever more than offset the extra payment at 5.6%, but if you think you might live in the same home for a lot of years, locking into 5.6% would not be unwise.

The early 1980's were unusual times but the crunch of 1990-91story is similar. The peak of the drop in home prices of about 8% occurred around August 1990, about the same time as the peak in gold and oil prices. Sales and starts made their bottoms around January 1991 with a peak year over year decline in sales of 15% and a peak decline in starts of about 45%. Mortgage rates peaked at about 10% concurrent with the peak decline in sales and starts. The payment amount on a $200,000 loan in January of 1991 was around $1,750, 52% above the payment required today on a 30 year loan!

It is important to note that the peak in commodity and oil prices (and CPI) tends to occur concurrent with the peak decline in home sales and prices. However, a big decline in the price of gold started around August of 1990 in line with the turn in prices and 4 months prior to the bottom in sales and the bottom in housing starts.


Potential home buyers are currently erring on the side of caution. Buyers are waiting to see if the worst is over. The waiting bet is a bet on either lower house prices or lower interest rates or both. With help being provided to the markets by the FOMC, it is difficult to project significantly lower 30 year mortgage rates. Should the FOMC increase the money supply to bring down short rates, the higher the probability of long term inflation and thus the higher the probability of higher 30 year mortgage rates.

With mortgage rates already very close to historic lows, the buying power of the consumer has been pushed upward. It is hard to see lower home prices except in formerly overheated markets such as Florida, California, Arizona and Nevada because the flood of 2 million homes on the market is concentrated in these markets. In NC the price of the average home went up 2-3% in the past year. While 2-3% is not a large number, this was in the face of the worst of the crunch. NC home prices could easily jump 10% as soon as the "all clear is sounded".


In each prior case, when housing starts got to a year over year decline of 40% or more (this includes the 1970's), the stock market had made its turn and was on the way up! This is really no big surprise as lower interest rates, the "raw material of business" is the routine result of housing crunches. The back to back, double recession of 1980 and 1982 saw a "double dip" in the stock market but the market was on the way up when the low was made in 1980 and the market was up in less than a year after the second bottom in 1982. Indeed, one of the best ever times to buy stocks was at the bottom of the home building bust in 1982.


The CRB index of 19 commodities fell 8.3% last week! This was the biggest one week decline in this index in over 50 years of record keeping. This decline occurred while the PCE (the FOMC's favorite inflation gage) was running at below 2%! The big drop was bound to happen as the real money base which was growing at 0% in 2006 is now seeing "negative growth" of 3% in 2008. Unit labor costs are minus 2%! How can we square these numbers with the hype being dished out by financial reporters? Part of the answer is that the CPI is the measure used to "adjust the numbers" and the CPI is a poor way to measure inflation. As a result of the goofy use of the CPI index, real retail sales were slightly negative last month, however, as the collapsed prices of commodities works its way into the CPI numbers, adjusted retail sales will get a strong boost. With sales only slightly negative, a small decline in the CPI growth rate will produce sudden "strength" in the economy.


While the "phony inflation jump" makes consumer spending look weak, the value of oil imports is serving to camouflage the strength in capital goods. Take petroleum out of the trade figures and we discover that the US trade deficit fell from 42 Billion in 2005 to a current annual rate of 23 Billion. It is clear that the US dollar has fallen to a "clearing price". At current prices, more and more foreign investors will build more and more facilities in the USA. These investors will enjoy higher sales from the US while they also enjoy catching the rebound in the value of the dollar.


Government bureaucrats have played around with the leading indicators and the result has been more hype. Much has been made of the fact that the leading indicators have fallen 5 months in a row. The facts are that the average work week is still strong, that vendor performance is only a little weak, that capital goods orders are booming and that unemployment (a lagging indicator) is still in check and at best the indications are for a weak slowdown not a major recession. The main take away for the investor is to note that the stock market is the number one leading indicator of economic strength and the internal market bottom make on January 21 has held. The market move since that date suggests that the worst of the economic slowdown will soon be behind us (stock prices will be well on the way up long before the weakest point in the economic cycle).


The elasticity of oil demand in China is extreme. From 1998 to 2004 the rate of economic growth in China went from 7.7% to 10% and the growth in demand for oil went from 2.5% to 16% (a 30% change in the economic growth rate resulted in a 640% increase in oil demand). Investors should remember that this sensitivity works in both directions. For example, when economic growth fell from 14% to 11% from 1993 to 1994, the growth in demand for oil fell from 12% to 2%. The most recent numbers from China suggest that the growth rate there will fall from last years rate of 11% to this years rate of about 7.5%. The USA has a much more stable economy and yet the last for weeks of data show an implied demand decline here of 3.2%. The current price of oil is causing demand destruction.


Given the choice of big government or big business, I would chose big business every time. Hillary and Obama continue to attack the big oil companies. The fact that big oil has made big profits in the past few years comes out as being "un-american" in the words of these politicians. Oil companies are an easy scape goat for the mistakes made by the congress. We live in a country that owns 50 years of natural gas supplies, not counting all the trillions of cubic feet a few miles off our coast lines. We live in a country blessed with 200 years worth of coal. We live in a country that owns owns about 3 trillion barrels of shale oil. We also live in a country where rich farmers are paid to grow corn to put into car engines.


Shares of big oil owned in pension fund accounts--41%.
Shares of big oil owned in mutual funds--29.5%.
Shares of big oil owned by individual investors 23%.
Shares of big oil owned by institutional investors 5%.
Shares of big oil owned by corporate insiders 1.5%.

An attack on big oil is an attack on the retirement savings of Americans.

Institutional investors own 5% of big oil and 95% of airline shares! Which do you think is the better buy?

Eighty percent of the worlds oil reserves are owned by foreign governments. The Hillary solution, to tax big oil companies, is to tax those who control 1.6% of all supplies. If Hillary were to pay farmers to grow corn on 100% of all the farm land in America, we would only produce 12% of out needed supplies.


CNW Marketing Research has produced the work to show the silliness of government solutions. Governments from New York to California have subsidized or mandated the use of hybrid cars. The research shows that the total cost of the lowest cost hybrid, the Honda Insight, is $2.94 per mile, cradle to grave. In contrast, the total cost of a Hummer III is $1.94 and the cost of a Ford Escort is $.57 per mile. The hybrid cost 5 times more than the Escort per mile and these costs convert into environmental savings. The cost of metal and chemical batteries is high in terms of dollars and in terms of damage to the environment.

At the same time that the American consumer is being hoisted on the environmental petard, we can use Google Earth to view new activity at Saudi Oil fields and the lack of activity in protected areas in North America. Even so, the US government auction of oil drilling rights in the Gulf of Mexico just set a new record. The government just accepted thousands of bids that totaled more than 3.6 Billion Dollars of revenues to state and federal governments.

Furthermore, the variety of research that is being done is amazing. One of the latest discoveries has boosted the efficiency of themo-electric conversion by 40%. The fact is that if just a fraction of the wasted heat in the world could be converted into electricity, the cost of produced energy would drop dramatically. Oil refineries have done a remarkable job of using excess heat from the refining process to "co-generate" the electricity needed to run the refineries. There are millions of other manufacturing processes where excess heat is not routinely captured. The average car in America converts only 16% of the energy spent to "work". The latest discovery is a material that can extract electricity from a room temperature environment and it works well up to 250 degrees.

Converting heat to electricity takes advantage of the law of conservation of energy; energy is never destroyed but it is simply moved from one area to another. Why pay to cool a sun soaked building if the excess heat can be converted to electricity?


The solutions to the price of energy all take various lengths of time to have an effect, however, progress is cumulative. Past big declines in energy prices marked prior turns in financial, retail, housing and tech stocks. The market is showing a lot of green this morning while oil is only off 10% from all time highs. Further declines in the price of oil will bolster the markets all the more.