Thursday, December 15, 2005

“Predicting the Rain Isn't as Important as Building the Ark” – unknown

"The collapse of the housing bubble will throw the economy into a recession, and quite likely a severe recession," July report by the Center for Economic and Policy Research, November 2005.

"The demographic story behind the housing market boom, as we always thought, was a giant hoax," David Rosenberg, Merrill Lynch economist, November 2005

The Federal Reserve, as expected, hiked short term rates for the 13th Fed meeting in a row. The target for the Fed Funds rate now stands at 4.25%, up from 1% just 18 months ago. The language of the Fed’s policy statement has changed slightly; expect at least 2 more ¼ point increases in the months ahead. The Fed Funds future’s market is discounting 4.75% no later than the May ’06 meeting, and quite possibly by the March ’06 meeting. With the 10-year Treasury bond closing to yield nearly 4.5%, it appears unlikely that the 10-year could very well close the year yielding 5%. Still, that bond has lost 5% of its value in 4 months, over 1 years worth of interest. 30 year “conforming” mortgage rates will be in the 6.25% to 6.5% range (jumbo and commercial mortgages will be somewhat higher), and adjustable rate mortgages not much cheaper. What a difference a year makes.

So much capital is sloshing around the globe that asset prices in every industrialized country have been bid up to the point that Fed Chairman Alan Greenspan felt compelled to warn investors that past periods of low “risk premiums” (those of you reading my commentary will remember this term and definition) demanded by investors had not been “kind” to investors. Herewith his recent remarks:
“[the] vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”
“Greenspan speak” frequently requires translation. Please feel free to call me directly and I will be happy to expound.
Lets get back to “Building the Ark”. I love Real Estate. I hate losing money, poor returns, and high risk/low reward investments. My comments in this forum over the past 8 months have certainly had a negative slant when discussing this asset class, particularly in the South Florida market. I enjoyed a nice visit on the phone with a substantial Real Estate investor/attorney, and during the conversation he asked me when my predicted “crash” in Real Estate values would occur. I was somewhat disappointed in his interpretation of my diatribes and hope to be clearer in the future. Real Estate, for the most part, does not crash; it experiences “corrections” and “cyclical downturns”, or it may become difficult to sell at all. Unlike a bond or a stock or other financial asset, Real Estate has carrying costs. If the property does not generate self-liquidating cash flow, these carrying costs add up rather quickly. Here is one of my favorite quotes from Tim McGinn, a respected Wall Street investment banker I met during my days at Bear Stearns:

“The gross overbuilding of the 1980’s has taught real estate investors that tenants are what matter most. Without them, architecturally stunning, exquisitely located, and ingeniously financed buildings move rapidly to foreclosure.”

My concern is the direction of interest rates coupled with what appear to me to be super-stretched asset prices. I have been through a couple market disasters in my life. Not one was predicted the week prior to the crash in the Sun-Sentinel or even the Wall Street Journal, so you cannot look for signs in the newspapers. I have never in my life heard a real estate salesperson or stockbroker that wasn’t “constructive” (outrageously bullish) on their market place. After all, they get paid to be optimistic! Yet the 20th century was replete with corrections, bear markets, financial dislocations, currency crises’, credit crunches, war, etc… Real Estate is now considered by the average, individual investor to be the “can’t lose” asset class of choice, while stocks are thought to be incredibly risky, and because of easy credit individuals have, in my opinion, bid up the price of many Real Estate markets to the point where the risk/reward ratios are poor. Too much of American’s balance sheet assets, if you will, are in Real Estate. Remember, broad diversification is the key to surviving any “market correction” or “cyclical downturn”.

“All eyes on the Dollar”

The Dollar, somewhat predictably, has rallied from its lows against the major currencies by virtue of the Fed’s activities, but has stalled near current levels despite several rate hikes. This is important stuff. The current account and budget deficits are nothing short of frightening to people of my ilk, but do not seem, at this time, to be bothering many others. The Dollar might very well continue on its rally in spite of the twin deficits because of little competition from other market’s fixed income securities. Or it might not. If not, look out for significantly higher long-term rates, falling asset prices (attention real estate speculators!), and tough going in all U.S. markets. Here is a graph of the DX:


The last 3 Fed hikes failed to rally the dollar above 91. The market anticipates an additional 3 hikes before the end of Q2, 2006. If the dollar fails to rally with these subsequent hikes… well let’s just say it is worth watching.

“All eyes on Oil, too”

Oil continues to defy those who thought this was an asset bubble created by financial investors (dry barrels) rather than the physical (wet barrels) market. There are a significant number of smart people that believe that we have passed the peak in world oil production. Is it this year or the next or the year after? I don’t know. But the consequences of $100+ per barrel will be significant, and not just at the gas pump. This development will reward some and punish others. I highly recommend “Hubbard”s Peak” by Kenneth S. Deffeyes, and a short white paper easily found on the Web “The End of Cheap Oil” by Colin J. Campbell and Jean H. Laherrere. This issue is here to stay.


The Santa Klaus rally came early this year. Looking forward, this asset class will be driven by interest rates, energy prices, and geopolitical outcomes. I need a better sense of where the aforementioned are going before I

Let’s review this year’s prognostications: Our readers would have steered clear of speculative housing bets; check! They would have over weighted equities; check! Under weighted bonds; check! Remember, things change: The U.S equity market has rallied significantly, and is not as attractive as it was, in my opinion, and we are again rebalancing out asset allocations towards more international exposure and less domestic exposure. I do not speak in absolutes (I did not say no exposure) – only in probabilities. It is probable, in my opinion, that the U.S. will not be the leading equity market in terms of appreciation in 2006.

1 comment:

DFW Real Estate said...

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