The stock market sold off sharply last Wednesday, confirming that the sell-off exactly one week prior quite likely punctuated the five week rally off of the August 13th low. The VXO hit an absurdlylow reading of 12.66 the day prior to Wednesday�s 15-point decline, which marked the worst performance for the S&P 500 since August 6th, shortly before the current rally began. We will likely seea VXO reading north of 20 before the current sell-off ends and another oversold bounce begins.
Interest rates continue to fall at the long end as bond investors price in the coming recession. The 10-year Treasury yield hit a low of 3.98 on Wednesday before bouncing into the weekend. The drop below 4.05% violated an up channel which has been developing since June 13th of 2003, and opens the way to a further decline, which could see the 10-year retest the March low at 3.68% in the coming months. Again, we believe that bond investors are pricing in a consumer-led recession, which should arrive sometime in early 2005. (The leading indicators index fell in August for the 3rd month in a row � ominous at the very least).
We wrote last week about the potential effects of continued high oil prices – something we are forecasting � focusing on the likely drop in corporate cash flows that would result. There are a number of other reasons why corporate cash flows are likely to disappoint in 2005, chief among them the lack of buying power by both the government and the consumer. Both potential sources of demand are tapped out. Personal indebtedness reached a record 140% of disposable income in the first quarter of 2004 while �the Fed�s broad measure of households� financial obligations to service debt has been hovering around 18.5% of income � a record proportion, notwithstanding the very low rates of interest,� according to the Levy Economic Institute. The authors of the recent paper go on to project a federal deficit of nearly 9% of GDP by 2008, given the government�s current fiscal policy and current growth projections for the economy of 3.2% per annum. A 9% of GDP federal deficit weighs in at over $1 trillion and far surpasses the old record deficit of about 6% of GDP from the Reagan era.
It is quite likely that a new period of fiscal rectitude will arrive with the next administration, regardless of who wins the presidential election in November. And it is hard to imagine that corporate cash flow won�t be negatively impacted by a cut in fiscal deficits. because the private and foreign sectors aren�t likely to replace the diminished demand from the government. In fact, we think that the household savings rate is going higher, possibly as high as 6% of disposable income over the next few years, as consumers repair heavily leveraged balance sheets. Because�
The major influence on household savings appears to be wealth � one need only look at a chart of the household savings rate and wealth to see the high degree of correlation over the last 60 years. The main sources of wealth are real estate, equities, and pension assets in the United States, with real estate accounting for the largest amount. Regular readers are well aware that we believe the U.S. stock market is still overvalued (based on 100+ years of data that measures value using Tobin�s Q and a trailing 10-year average P/E ratio). What they might not know is that the U.S. housing market is further above its trend level of appreciation than at any time since WWII. There is a high probability that household savings will rise as both equities and real estate move closer to fair value in coming years.
Let�s talk real estate this week:
Anecdotal evidence points to a housing bubble: Real estate investment clubs are springing up all over the country. California now has 40, Florida 50, and the Georgia real estate Investor Association has drawn as many as 1,000 members for its monthly meetings. Last year 34 metro areas showed double-digit price appreciation. In fact, a survey of nearly 700 home owners in Boston, Milwaukee, San Francisco, and California�s Orange County by Karl Case of Wellesley College and Robert Shiller of Yale finds that the average person is expecting double-digit growth each year for the next 10 years. However, home prices have actually only appreciated a little over 1% per annum after inflation. The major disconnect between people�s expectations and reality is eerily similar to the disconnect experienced by the typical stock market investor in the late 1990s.
Statistical evidence: American house-price inflation clocked in at 9.4% in the year to the second quarter, the highest since the 1970s. House prices have increased by more than twice as much in real terms since the mid-1990s than they did in the 1970s and 80s. Home prices are now at record levels in relation to average incomes in America, Australia, Britain, France, Ireland, the Netherlands, New Zealand, and Spain, according to the Economist. In fact, America�s ratio of house prices to rents is at a record high, 26% above its average over the last 25 years, states the Economist. By that magazine�s calculation, it would take eight years of stagnate home prices to bring the ratio back to average levels. Finally, vacancy rates are at their highest levels since 1965.
Which brings us back to the consumer, wealth, and the household savings rate. A Goldman Sachs� study finds that swings in house prices has a significant impact on consumer spending in America. What happens to consumer spending if, instead of stagnating, home prices actually decline in real terms?
Christopher Norwood manages the Keystone Fund, and the Keystone Stable Fund. To learn more about Chris and the funds he manages CLICK HERE.
Disclaimer: Chris Norwood is the president of Thunderbird Management, which manages three hedge funds in Indianapolis, Indiana. Mr. Norwood periodically publishes columns expressing his personal views regarding particular securities; securities market conditions, and personal and institutional investing in general, as well as related subjects. Mr. Norwood�s columns are not intended to constitute investment advice or a recommendation to buy, sell, or hold any security.
