HousingStorm.com

Phil the groundhog has a real future as an economist; both try to predict the future. Some things are predictable like Winter which, by the way, lasts until Spring every year so there are always six weeks left after groundhog day. People are somewhat predictable, but not completely. Psychologists try to understand why people do what they do, but are often surprised. One thing I have noticed is that people get tired of the bad economic news and pessimissm. I have written several times before that economics is about supply and demand. Supply is something you can easily inventory. You can go out and count your widgets, and you can measure the cost to produce that inventory. Measuring demand is a little trickier. Demand gets into the psyche of the consumer, and the only pure metric of demand is the actual purchase of goods and services. That only measures the past, so how do we predict the future?

There is no crystal ball that answers what future demand will be. If there was, I am sure the banks, wall street and the US automakers would not have been looking for bailouts this past year. We do have the consumer confidence index which has been a somewhat reliable indicator for future purchases. The latest index just came out last week stronger than expected at 55.9. That was the third month in a row marked by an improvement in a quarter that saw a 5.7% growth in the economy. Of course, much of the growth is not sustainable being fueled by federal stimulus money. The third quarter also posted a modest expansion as fiscal and monetary policy started taking hold. So, is consumer optimism helping create the expansion or is the expansion generating greater consumer optimism? Either way, with two quarters of growth behind us, it is time for the consumer to take the lead again. Consumer spending is the biggest and most sustainable driver of our economy, and I don’t want to wait six more weeks for Spring.

Orlando Real Estate, David Welch Real Estate Optimist, As Seen On HGTV’s House Hunters

Readers regularly ask me to weigh in on the question “should I buy a house now or not?” Here are a few key considerations. Has the housing market bottomed? Is now a good time to buy a house if you’ve been waiting patiently for years? I receive queries like this on a regular basis, and my responses do not take the form of advice–after all, how can anyone know the reader’s full financial/ family situation except the reader? And how can anyone outside the area possibly know the many variables of the local real estate market?

The only thing I can offer is a context for analysis and decisionmaking.

Let’s start with the big question: Is this the bottom? Despite a very sharp bounce in sales and prices in some beaten-down markets like San Diego (please see California Housing Forecast for particulars on the multiple bidding environment which took hold there in 2009), the short answer is “probably not, based on bubble symmetry and the fundamentals of supply and demand.”

Let’s stipulate two points:

1. Housing/real estate was a classic speculative bubble.

2. All speculative bubbles tend to track a symmetrical pattern.

Simply put: if the bubble took seven years to reach its blow-off top, then its decline will typically take a similar length of time as prices fully retrace to pre-bubble levels. Here are some charts that illustrate the point.

This is the Nasdaq dot-com speculative bubble, which traced out a sharp rise and decline somewhat like the Tulip Bulb Mania and other previous speculative bubbles. The key feature to note is how eager “bottom fishers,” still caught up in the false promise of “easy wealth in real estate/tulip bulbs/the Internet” etc. jump in far too early, creating brief spikes in demand and thus price.

Then supply once again overwhelms demand, which falters, and prices resume their decline. As for falling demand:

Existing home sales plummet 16.7% in December.

As for supply: it is common knowledge that hundreds of thousands of homes are currently in the limbo of “shadow inventory”–homes the lenders won’t foreclose for fear they can’t be sold, homes held off the market by owners who are deeply underwater on their mortgages, etc. As soon as demand appears, then supply rockets up as those anxious to sell then shift properties from the “shadow inventory” into the market.

The other feature to note in this chart is that the dominant speculative belief (in this case, that “real estate is the foundation of easy wealth creation”) takes years to expire.

This is a chart I prepared as the housing bubble climbed toward its ultimate peak in 2006/early 2007. It suggests that the next leg down in still-overpriced markets is about to begin, and that the final bottom will probably not be reached until the 2013-2014 time frame.

So the answer to the question “what is fair value?” is consistent: pre-bubble prices, that is, whatever the house fetched in the 1994-7 timeframe.

Here we see that national home prices have already retraced to 2002 levels–about halfway down the slope to a full retrace. Once again we see that bubble symmetry suggests the final bottom will not be reached until 2013-2014.

In some once-hot areas, prices have already returned to pre-bubble valuations, or even lower. If this metric has been reached, then we need to ask these additional questions about any potential purchase:

1. Does the property have any inherent value, i.e. is it close to centers of jobs and commerce, have deep soil and good water, solidly constructed, etc.? A poorly constructed McMansion sitting forlornly in an exurban development that’s unoccupied and falling to pieces, far from jobs and any social life, is doomed to be bulldozed. Its location and construction served no purpose except speculation. Since it is poorly built, then even a price of $1 is too expensive because it will be a money pit to maintain/repair.

2. Is the total cost of ownership–mortgages, insurance, property taxes and routine maintenance expenses–substantially lower than renting an equivalent home? One reader recently purchased a home with a substantial down payment with the net result that his monthly housing costs (not counting any large maintenance expenses like a new furnace or roof, of course) dropped to below $600/month compared to $900/month for the house he was renting.

The danger here is that as the supply of rental homes and apartments rises, rents are already dropping in any locales. That is, rent is not a fixed number but a moving target. Rents may decline for years if demand remains lower than supply.

On the other hand, areas close to jobs and commerce might see rising rental demand as people try to move closer to jobs, schools, social life, etc. as rents in these desirable areas decline.

3. Can you afford to have the capital (down payment) tied up in illiquid real estate? Given the financial uncertainties, it might not be wise for anyone to dump all their cash savings into a house which cannot be readily sold should some other pressing need arise.

4. Are your sources of household income stable and not subject to the whims of Corporate America’s penchant for transfers? There are few better ways to churn through a fortune than to buy a house in a disintegrating market and then be forced to sell due to a Corporate relocation, then buy another home near your new assignment. Losing money every month supporting two homes, both of which are losing value and neither of which can be sold for their purchase price–this is a financial nightmare to be avoided at all costs.

5. Can the mortgage, taxes, insurance and maintenance be paid by one income in a two-income household? Job security is a relative term as corporations shed jobs, small businesses fold and local government finally faces the double-bind of declining tax revenues and increasing pension costs. Thus it is prudent to align housing expense such that one income can cover the bills if someone in the household loses their job.

For renters, the loss of one income can be met by moving to a cheaper rental. A homeowner has no such flexibility.

Bottom line: what are the consequences if housing continues declining for 3-4 more years? If housing in a locale has already fully retraced to pre-bubble valuations, then the rest of the questions can be used to construct a decison tree.

In an economy which is disintegrating on multiple levels, it’s prudent to ask “what if?” questions and think through “worst-case scenarios” before committing capital and making a long-term commitment to a property.

At the 2010 International Builders Show this week in Las Vegas, the NAHB’s chief economist David Crowe is predicting a rise in home starts for the spring, a dip mid-year (as tax credits expire) and then another rise by the end of 2010. From BigBuilderOnline.com:

The pace of housing starts will speed up this spring, slow and perhaps reverse course at mid-year, and then re-accelerate next winter and into 2011, the National Association of Home Builders’ chief economist forecast today.

David Crowe said the number of combined single and multifamily housing starts will rise from an annual rate of 565,000 in 2009’s first quarter to 677,000 this quarter. He forecast starts would climb to 688,000 in the second quarter of 2010, slip to 669,000 in the third quarter, and then rebound to 754,000 in the final three months of 2010.

Starts will keep escalating robustly in 2011, he predicted, climbing from an annual rate of 870,000 in the first quarter of that year to 1.22 million in October through December 2011…

Click here for entire story.

So it this unbridled optimism from the building community or does it seem realistic?  I guess we’ll find out!

Last week we delved into the uncertainties that face us and that make forecasting for 2010 problematical. Will the government actually increase taxes as much as they say, with unemployment still likely to be at 10%? Or will cooler heads prevail? Would such an increase cause a recession? Will the markets anticipate the effects of such a major increase in advance? How will the mortgage market react when the Fed stops buying mortgage securities at the end of March? There are so many things in the air, and today we explore more of them, as I continue (perhaps foolishly) to try and peer into what is a very cloudy crystal ball.

When the Fed Stops the Music

The Federal Reserve has been very clear about the fact that they intend to stop the quantitative easing program at the end of March. What that means in practice is that they are going to stop buying mortgage securities. That does two things. As Bill Gross so aptly points out, those mortgage purchases helped keep mortgage rates low. But they also financed the US government fiscal deficit, albeit indirectly. It seems that funds and banks that sold the mortgage securities turned around and bought US government debt or put the cash right back at the Fed.

Foreigners bought about $300 billion of the $1.5 trillion in new government debt. The rest came from the US, courtesy of the Fed buying mortgages. But that program stops (theoretically) at the end of March. The government still plans to run yet another $1.4-trillion-dollar deficit (give or take a few hundred billion). The question is, who will buy the debt? Foreigners will kick in another $300 billion, unless they decide to stop selling us stuff, or buy other less liquid or physical assets. So far there is no sign of that.

But as I asked last year, who is going to buy the multiple trillions in government debt that the G-7 countries want to issue? Who is going to buy another $1 trillion here in just the US? That is 7% of GDP. That means that consumers and businesses will have to save an additional 7% of GDP just to finance government debt at the federal level, not counting state and local debt. As Bill Gross concludes in his recent column (www.pimco.com):

“The fact is that investors, much like national citizens, need to be vigilant, and there has been a decided lack of vigilance in recent years from both camps in the U.S. While we may not have much of a vote between political parties, in the investment world we do have a choice of airlines and some of those national planes may have elevated their bond and other asset markets on the wings of central bank check writing over the past 12 months. Downdrafts and discipline lie ahead for governments and investor portfolios alike. While my own Pollyannish advocacy of ‘check-free’ elections may be quixotic, the shifting of private investment dollars to more fiscally responsible government bond markets may make for a very real outcome in 2010 and beyond. Additionally, if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009. It seems no coincidence that stocks, high yield bonds, and other risk assets have thrived since early March, just as this ‘juice’ was being squeezed into financial markets. If so, then most ‘carry’ trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their ’sugar daddy.’”

This is yet another uncertainty. We simply have no idea, no relevant marker, for what happens when a country goes so cold turkey, coming off a central bank bond-buying binge. And this in the midst of a massive deleveraging and with stock market valuations basically where they were in 1987 – except there was at least large earnings growth then.

Who Wants the Old Maid?

Why, therefore, would anyone want to be long the dollar or treasuries? The dollar may be the worst currency in the world, except for all the others. What’s an emerging-market central banker to do? Where do you put your reserves?

The dollar? With large fiscal deficits and low interest rates? “What are my other choices?” they must be asking themselves. The euro? Really? The euro is not a currency, it is an experiment.

Everyone knows the problems of Greece. There is no political will in the country (so far) to do what Ireland has done, and really cut their budget. I think Spain is an even bigger nightmare for the EU when compared to relatively small Greece. Italy? Belgium? Portugal? All those countries (and their voters) will be watching to see how the EU deals with Greece. The potential for volatility in the euro is just huge. I hope the euro survives. The world is better off with the euro. But there are very large pressures facing the Eurozone.

And what about the British pound? Already down 20% (a little relief for my London trip next week!), and their problems are every bit as large as those in the US. What about the yen? The government has let it be known they are not happy with the rise in the yen, and seem ready to actually do something about it.

What about the Renminbi? Oh, wait, you can’t get enough of them, and the Chinese manipulate their currency. Same for most other Asian currencies.

The dollar may rise against the major currencies during the first part of the year. As I wrote weeks ago, world trade is slowly picking up. While that growth has not been very visible in the US, it is becoming evident among the emerging-market countries that were not overly leveraged when the crisis began. And trade is still in dollars.

Businesses sold their dollars during the crisis, as they did not need them for trade. But now, with trade picking up, they once again have to buy dollars. That is one reason for the recent bull market in dollars. The other is that the markets are massively short the dollar. When everyone is on the same side of a trade, that trade may have run its course, at least for a while. And that seems to be the case recently for the dollar.

So, where are the strong currencies going forward? The Canadian dollar is on its way to parity. I would want to own the Aussie, if I was a trader. Maybe the Swiss franc, although it is so high on a parity-value basis right now.

But the currency I want the most if I am a central banker is that barbaric yellow relic, gold. Just as India has recently bought 200 tons of gold, I think central banks in other emerging nations will want to buy more, too. They all have relatively little gold as a percentage of their reserves. Look for that to change.

I also like gold in terms of the euro, the pound, and the yen – more than I like it in terms of the US dollar, but even there I like gold long-term, at least until we get some fiscal sanity.

It’s the Deleveraging, Stupid!

The reason this recession is different is that it is a deleveraging recession. We borrowed too much (all over the developed world) and now are having to repair our balance sheets as the assets we bought have fallen in value (housing, bonds, securities, etc.). A new and very interesting (if somewhat long) study by the McKinsey Global Institute found that periods of overleveraging are often followed by 6-7 years of slow growth as the deleveraging process plays out. No quick fixes.

Let’s look at some of their main conclusions (and they have a solid ten-page executive summary, worth reading.) This analysis adds new details to the picture of how leverage grew around the world before the crisis and how the process of reducing it could unfold. MGI finds that:

• Leverage levels are still very high in some sectors of several countries – and this is a global problem, not just a US one.
• To assess the sustainability of leverage, one must take a granular view using multiple sector-specific metrics. The analysis has identified ten sectors within five economies that have a high likelihood of deleveraging.
• Empirically, a long period of deleveraging nearly always follows a major financial crisis.
• Deleveraging episodes are painful, lasting six to seven years on average and reducing the ratio of debt to GDP by 25 percent. GDP typically contracts during the first several years and then recovers.
• If history is a guide, many years of debt reduction are expected in specific sectors of some of the world’s largest economies, and this process will exert a significant drag on GDP growth.
• Coping with pockets of deleveraging is also a challenge for business executives. The process portends a prolonged period in which credit is less available and more costly, altering the viability of some of business models and changing the attractiveness of different types of investments. In historic episodes, private investment was often quite low for the duration of deleveraging. Today, the household sectors of several countries have a high likelihood of deleveraging. If this happens, consumption growth will likely be slower than the pre-crisis trend, and spending patterns will shift. Consumer-facing businesses have already seen a shift in spending toward value-oriented goods and away from luxury goods, and this new pattern may persist while households repair their balance sheets. Business leaders will need flexibility to respond to such shifts.

You can read the whole report at their web site. The ten-page summary is also there. http://www.mckinsey.com/mgi/publications/debt_and_deleveraging/index.asp

The Lex column in the Financial Times this week observes, concerning the report:

“It may be economically and politically sensible for governments to spend money on making life more palatable at the height of the crisis. But the longer countries go on before paying down their debt, the more painful and drawn-out the process is likely to be. Unless, of course, government bond investors revolt and expedite the whole shebang.”

And that is the crux of the matter. We have to raise $1 trillion-plus in the US from domestic sources. Great Britain has the GDP-equivalent task. So does much of Europe. Japan is simply off the radar. Japan, as I have noted, is a bug in search of a windshield.

Some time in the coming few years the bond markets of the world will be tested. Normally a deleveraging cycle would be deflationary and lower interest rates would be the outcome. But in the face of such large deficits, with no home-grown source to meet them? That worked for Japan for 20 years, as their domestic markets bought their debt. But that process is coming to an end.

James Carville once famously remarked that when he died he wanted to come back as the bond market, because that is where the real power is. And I think we will find out all too soon what the bond vigilantes have to say.

And so we have uncertainty all around us. What will our taxes look like in the US in just 12 months? Health care? Who will finance the bonds, without a credible plan to reduce the deficit? And any plan that has Nancy Pelosi as its guarantor is by definition not credible.

There is just so much that is uncertain, and all we can do is wait to see how it unfolds. My best guess is that we see a solid GDP number posted for the 4th quarter (which will get revised down over time), due mostly to stimulus and inventory rebuilding. By the middle of the year the stimulus will be far less. And while inventories are rebuilding and that is good for the GDP numbers, the sales-to-inventories number has not risen. And final demand is what drives inventory rebuilding.

The latter half of the year looks to be weaker, and then we hit what right now looks like the largest tax increase in history, much of it on the small businesses that are the drivers of job creation. The National Federation of Independent Businesses just released their latest survey. It was brutal. There is little optimism in it.

The Fed is going to stop the music in March. There will be a scramble for the chairs. This is a huge experiment with no precedent. The entire developed world is the test subject. Risk assets will be subject to uncertainty. And markets hate uncertainty.

Hopefully, we can Muddle Through this year before a relapse into recession in 2011 (because of the tax increase). I wish I could see it like Larry Kudlow, but I don’t. I would be very cautious about being long the stock market. It is now a trader’s market. I would not be buying long-duration bonds. It is still an absolute-return world.

                                                                                                                                                                                                                                                                                   It is now 2010 and many are wondering what this year will hold for the real estate industry. My predication is there will be some changes, but a lot will be the same. Here are my 6 predictions for the year ahead.

1. Foreclosures. Foreclosures are not going away albeit in my opinion we will not necessarily see a flood of inventory. Yes there is a back log of inventory and yes banks do want to get these properties off the books. BUT and the big but here is inventory is down; many of the foreclosures in the East Bay are selling with multiple offers in a shorter amount of time. If you look at this strictly from a business standpoint why would the banks want to flood the market with inventory to have prices come down and have property languishing on the market?

2. More Foreclosures in Higher End Markets.Many of the higher end markets in the East Bay such as Rockridge, Montclair, Crocker Highlands, the Lakeshore area and Piedmont did not feel the pinch when the first wave of foreclosures hit the market. With more buyers in the “first time” home buyer market (≤ $729,750, the limit for the FHA jumbo conforming loan limit), and many of the home owners in these areas purchasing their homes with interest only or ARM financing, there will be more foreclosures in these areas. Do I think we will see a huge wave as we did in the lower end market, no. But there will be more than have been seen in the past.

3. Lower Inventory. In my opinion we will continue to see lower inventory than has been experienced over the last couple of years. With many of the foreclosures off the books and many home owners choosing to stay put if they can, we will see less inventory in the marketplace. In addition, the banking industry seems to like to make money and with inventory down and prices beginning to stabilize, I am not sure if they want to go back to a glut of inventory and buyers calling all the shots…

4. Short Sales are here to stay. Many buyers and agents shy away from short sales because of the unpredictability of the outcome. Many times you can wait around for months for a response to only find out that the bank is not willing to participate. Some banking institutions are better than others, and there is a lot of pressure for the banks to work with homeowners when selling their home as a short sale. I have started seeing many of the agents who sell foreclosures starting to sell short sales. In some instances the lenders who would be obtaining these homes through the foreclosure process are begging to look as short sales in lieu of foreclosure.

5.Pricing to Begin to Stabilize. With a decrease in inventory and incentives for buyers to buy such as the Home Buyers Tax Credit and low interest rates, there will be brisk activity with first time home buyers which will help to start stabilizing prices.

6.Appraisals will continue to be a thorn in everyone’s side. With decreasing inventory and with some properties selling with multiple offers in areas, appraisals can be tough. I have seen appraisals come in significantly below the offer price and the property had multiple offers. There is not a whole lot of consistency across the appraisal community. And if the appraiser is coming to a city or community they are not familiar with, then it can be a disaster.

7.Interest rates will go back up. The last 6 months or so we have seen historically low interests rates. With the beginning of stabilization in the real estate market, interest rates will more than likely begin to creep back up.

2009 was a bit of a roller coaster ride and my prediction is 2010 will also be an interesting, but different, ride.

Default…  The Domino Effect

Defaults are like dominoes.  As more people default, it becomes more socially acceptable.  The Wall Street Journal recently reported that:

“Our research showed there is a multiplication effect, where the social pressure not to default is weakened when homeowners live in areas of high frequency of foreclosures or know others who defaulted strategically,” Zingales said. “The predisposition to default increases with the number of foreclosures in the same ZIP code.”

Just like anything that spreads that once was socially or “morally” questionable, such as drinking, smoking, spending more than you make via credit cards, strategic default has become a new social trend.  Joe Borrower decides he’s going to strategically default.  Joe feels passionately about his decision and shares it with his friends.  His friends start contemplating and weighing the option as well…

Until home values strongly recover, this trend will (and has) continue to spread like a wild brush fire.

UPI.com reported:

“Nearly one out of ten homeowners, 9.2 percent or 7.4 million homeowners, say they would likely walk away from their homes, default on their mortgages and suffer the consequences to their credit if they felt financially vulnerable and owed more on their homes than they are worth, according to a new national survey released today by Reecon Advisors, publisher of Real Estate Economy Watch.”

The last Mortgage Bankers Association report estimates that the total number of loans in some sort of delinquency, default, or foreclosure status to be about 8.2 million, or 14.41% of all loans. There was around 3.9 million foreclosure notices given in 2009, but if the total number of loans that are in some sort of delinquency, default or foreclosure presently is 8.2 million, it’s obvious that we have a bigger problem beneath the surface.  You can try to hide 8.2 million people in default, but at some point, you gotta know that you are only looking at the tip of the iceberg.

More foreclosures

Please consider CNN Money article: Jan 1, 2010

For Gus Faucher, the director of macroeconomics for Moody’s Economy.com, the huge number of foreclosures that remain in the pipeline is the big problem.

Moody’s upped its estimate of defaults recently because of shortcomings of the government-led mortgage modification programs. Trial workouts are not being made permanent and completed modifications are redefaulting at high rates.

“There are going to be fewer [successful] modifications than we thought,” said Faucher.

Even so, he added, much of the price decline has already occurred and Moody’s forecast is for only another 8% drop. The worst-hit markets will be the ones suffering the most foreclosures, places like Arizona, California, Florida and Nevada.

Resetting option ARMs (adjustable rate mortgages) will also aggravate the foreclosure problem. These mortgages allow borrowers to pick their own payments, which can be so low they don’t even cover the interest. Balances swell.

For many of the more than 350,000 option-ARM borrowers, it’s time to pay the piper. Their loans will change into fully amortizing mortgages that will carry much higher monthly payments. A very large percentage of these homeowners will default, according to Shari Olefson, author of “Foreclosure Nation: Mortgaging the American Dream.”

“We’ve still only seen the tip of the foreclosure iceberg,” she said.

The ice cold truth about our economy is that it is in a much worse state than people realize.  According to figures released by the Department of Labor, the real marker of American unemployment stands at 17.5 percent — a figure which takes into account under-employed workers and those who have not sought work in the last four weeks, according to a published report.

Debt Club

I want the economy to recover just as bad as the next person, I just don’t see how it can just yet with people out of work and with millions of homeowners worse off than renters.  We’ve been told that debt is bad, so why does the economy need so many people in debt for it to thrive?  Spend spend spend.   We need to spend more of our paycheck or max out our credit card, so that the local store won’t go out of business.

Here’s a good quote from Fight Club.

“…an entire generation pumping gas, waiting tables; slaves with white collars. Advertising has us chasing cars and clothes, working jobs we hate so we can buy s**t we don’t need.”

Most of us are guilty of it.   A mortgage is meant to be paid off eventually, right?  So why did the lenders invent interest only loans and negative amortization loans?  Clearly to take advantage of buy low and sell high.  Short term homeownership similar to the arbitrage that stock traders get rich off of.  Who benefits from the crashing real estate market?  The people who are buying the homes on the foreclosure auction block?  How is it possible that a home can become like a stock that goes up and down in value so much that it can destroy peoples lives.  If that is what homeownership has become, should we be looking at it more like a stock trader?  Buy low… sell high.

I hear people complaining about strategic defaulters, but what about the real people who created the bubble and the crash,  the ones who drove the ship into the iceberg.  Why get mad at the ones who are scrambling to occupy a seat on a life boat as the Titanic is sinking…

To big to fail?

This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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Since we just spent the last ten pages laboriously scratching the surface of complex macroeconomic trends with a few over-simplified charts, we will now analyze every single US housing market by looking at sales data in two cities.

As we wrote in April 2009, “The bifurcation of the real estate market continues, as troubles in the high end are picking up the slack while low-end markets grope for a bottom.” This trend has persisted for months, and as foreclosures creep into higher end markets, we believe the trend will persist for the foreseeable future.

Below are sales transactions for the past ten years in East Palo Alto. East Palo Alto, which in 1992 had the dubious distinction of being “murder capital, USA” by tallying the highest murder-per-capita rate in the entire country, has undergone a renaissance of sorts. Sort of.

As Silicon Valley wealth swelled during the dot-com boom, so too did housing prices. One of the last bastions of affordability on the Peninsula, real estate speculators flocked to this rough town for high risk, high reward development. The town experienced a decade of gentrification on steroids, as home prices became completely unhinged with the economic prospects of the area’s residents.

This story was repeated in cities across the country, each with it’s own unique flare. Vegas condos went through the roof. Track homes in Phoenix were flipped monthly by amateur and professional real estate speculators alike. Waterfront homes in the quiet town of Cape Coral, FL approached $1 million apiece.

But now, as prices in these markets have returned to earth, buyers are wading back in, armed with government loans, tax credits and a newfound fear of the stock market. Inventory is being constricted by ongoing foreclosure moratoria and in certain markets, prices have begun to stabilize.

The arrow below points out the steep price declines from 2007-2008 on few sales transactions. The shaded circle shows buyers stepping back in and prices groping for a bottom.

(click to enlarge image)

On the other side of Highway 101, the city of Palo Alto exists in precise contradiction to its neighbor to the east. Quiet streets, large lots and excellent schools make Palo Alto one of the most desirable places to raise a family in the entire country. Home prices, as one would expect, are very, very high.

Palo Alto residents have had decades of prosperity to accumulate wealth, and a few bad months in the stock market or the loss of a job doesn’t necessarily spell financial ruin. Fewer mortgage defaults, less dependence on credit cards and a general affluence meant that the bubble popped here later, and with less vigor. In other words, the “Price Discovery” (ie, a precipitous drop in prices resulting from a void of buyers, only to be stabilized as buyers step back into the market looking for bargains) that has occurred in East Palo Alto is yet to come to well-to-do areas like Palo Alto.

As can be seen from the green shaded oval below, Palo Alto experienced a mini-bubble on the tail end of the dot-com boom. Prices have now fallen to around where they were back in 2004, but only just below the maniacal glory days of Pets.com and WebVan. And, as foreclosures infiltrate these luxury markets, forced sales are becoming more common. This is beginning to drive down prices, as can be seen in the recent dip that picked up steam earlier in the year.

Luxury markets around the country have seen a similar trend in home prices: A later peak and less dramatic fall, but prices that are yet to be supported by opportunistic investors. But all is not bleak in other Palo Altos around the country.

These high-end markets have benefitted from the strong stock market of the past 9 months. If the economy can avoid another tumble and markets can remain resilient as the government gradually withdraws its stimulus, high end markets may find support sooner than many skeptics think.

(click to enlarge image)

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“Lying here, during all this time after my own small fall, it has become my conviction that things mean pretty much what we want them to mean. We’ll pluck significance from the least consequential happenstance if it suits us and happily ignore the most flagrantly obvious symmetry between separate aspects of our lives if it threatens some cherished prejudice or cosily comforting belief; we are blindest to precisely whatever might be most illuminating.”

– from Transition, by Iain M. Banks

Still a man hears what he wants to hear
And disregards the rest

– The Boxer, by Paul Simon

“They Are Rocking Even Me”

This will be my tenth annual forecast issue. Time has flown by, and I enter a new decade of writing Thoughts from the Frontline. And even as I write about the high level of uncertainty of the current times, I am optimistic that at the opening of the next decade we will look back and realize that there has been an enormous amount of progress made. None of us will want to revisit the pleasures of the past ten years in some nostalgic dream. I am so ready for a new decade. And speaking of Paul Simon (above), reading the lyrics of The Boxer, one of my favorite songs from my youth, another few words seemed to hit home:

…Now the years are rolling by me, they are rockin’ even me
…I am older than I once was, and younger than I’ll be, that’s not unusual
…No it isn’t strange, after changes upon changes, we are more or less the same

At the end of the letter I announce the dates for our annual Strategic Investment Conference, tell you about an important conference I will be attending next month for 9 days (a rather large chunk of time for me!), and drop a hint about why I am going to actually buy some stocks this decade.

For new readers (and a lot of you have joined us this last year), let me quickly tell you what it is that I really do. I basically read and think for a living. I read a lot – hundreds of newsletters, articles, papers, magazines, books, essays, emails etc., almost every week. Each Friday I sit down and write about what seems to me to be the most important ideas I have come across, often tying together concepts from multiple sources into what becomes this letter, hoping to piece together a few parts of the puzzle, to help us see the bigger picture. On Mondays I send readers Outside the Box, which is an article by some other writer that I find interesting, and I try to make sure that I disagree with more than a few of them. We need to think, and that is one way of helping us do so.

The letter started out ten years ago as a way for me to put into writing my ideas and thoughts on what I had read, and I sent it out to just 2,000 people. It has grown to where today it goes to around 1.5 million people and is posted on dozens of web sites. The letter is free. You can subscribe at www.2000wave.com simply by giving me your email address. And feel free to forward the letter to friends or put a link to it on your web site. And there are Chinese and Spanish translations of the letter each week as well.

2010: A Year of Uncertainty

I read and research more for the annual forecast issue than any other letter during the year. And having had the luxury of not writing for the last two Fridays, I’ve had even more time. It seemed to me that the volume of forecasts out this year was greater than ever. But even I was amazed when Birinyi Associates, Inc. showed a picture of annual forecasts they had come across and printed out. It was a stack almost two feet tall and comprising over 3,500 pages. They helpfully summarized the projections for the major investment banks and compared them.

Their work confirmed my own reading. The projections they cited and those I have read were all over the board and more divergent than I can ever remember. But as I read the tea leaves, there is a lot of uncertainty and caveats with these forecasts. And too many are based on assumptions that the future will turn out largely looking like the past. It has been my contention for a long time that we are in a period that looks nothing like the past, and to use backward-looking data to project the immediate future carries the risk of being very misleading.

Thus, before we get into my projections, I think we need to take a survey of where we are. That means this annual issue may turn into a two-week project (I generally try to stop writing at eight pages); but if you don’t know where you are, how can you figure out where you’re going?

This is a challenging time, and I am going to challenge a lot of people’s ideas over the next two weeks. So, as we start, let’s look at why we need to very carefully assess our belief systems. The two quotes at the start of the letter point out how difficult it is for us to accept an idea that challenges our belief system, or would have negative consequences for our lives. If we are long some investment, we look for good news that tells us our investments are going up, and gloss over the negatives.

Last month, I found out I was just a few thousand miles from becoming executive platinum on American Airlines. I have never attained that level, and there are some major benefits. So, the flight which was the least expensive and gave me the required miles was a two-hour hop to Tampa, where ironically I had been the week before. I flew back on the same plane 30 minutes later.

However, the time was put to very good use. I read a pre-publication manuscript of a book by my good friend James Montier, called The Little Book of Behavioral Investing. I was asked to write the preface. I have to say that this book will become one of those that I read at least once a year, as it just so pointedly reminds me of all the ways we make investment (and life!) mistakes because of the ways our brains are hard-wired.

One of the real problems is that we “hear what we want to hear.” Our beliefs or personal interests lead us to conclusions or actions that may or may not be helpful. Let’s take a page excerpt from James’ book:

Prisoners of Our Preconceptions

“For instance, a group of people were asked to read randomly selected studies on the deterrent efficacy of the death sentence (and criticisms of those studies). Subjects were also asked to rate the studies in terms of the impact they had had on their views on capital punishment and deterrence. Half of the people were pro-death penalty and half were anti-death penalty.

“Those who started with a pro-death sentence stance thought the studies that supported capital punishment were well argued, sound and important. They also thought that the studies that argued against the death penalty were all deeply flawed. Those who held the opposite point of view at the outset reached exactly the opposite conclusion.

“As the psychologists concluded: ‘Asked for their final attitudes relative to the experiment’s start, proponents reported they were more in favor of capital punishment, whereas opponents reported that they were less in favor of capital punishment.’ In effect each participant’s views polarized, becoming much more extreme than before the experiment.

“In another study of biased assimilation (accepting all evidence as supporting your case) participants were told a soldier at Abu Ghraib prison was charged with torturing prisoners. He wanted the right to subpoena senior administration officials. He claimed he’d been informed that the administration had suspended the Geneva Convention.

“The psychologists gave different people different amounts of evidence supporting the soldier’s claims. For some, the evidence was minimal; for others, it was overwhelming. Unfortunately the amount of evidence was essentially irrelevant in assessing people’s behavior. For 84% of the time, it was possible to predict whether people believed the evidence was sufficient to subpoena Donald Rumsfeld based on just three things:

1. The extent to which they liked Republicans

2. The extent to which they liked the US military

3. The extent to which they liked human rights groups like Amnesty International.

“Adding the evidence into the equation allowed the researchers to increase the prediction accuracy from 84% to 85%. Time and time again, psychologists have found that confidence and biased assimilation perform a strange tango. It appears the more sure people were that they have the correct view, the more they distorted new evidence to suit their existing preference, which in turns made them even more confident!”

“We’ll pluck significance from the least consequential happenstance if it suits us and happily ignore the most flagrantly obvious symmetry between separate aspects of our lives if it threatens some cherished prejudice or cozily comforting belief; we are blindest to precisely whatever might be most illuminating,” wrote Ian Banks, of the protagonist in the science fiction novel Transition I am currently reading.

(By the way, if you are a sci-fi reader and have not yet become addicted to the writing of Banks, start with his early work and move through the decades. He is one of the best hard sci-fi writers alive.)

Those who are invested in the idea of a “V”-shaped recovery became excited over the jobs report last month. Unemployment rose by only 11,000 jobs, if you did not look at the underlying numbers or ignored the household survey. And the consumer confidence surveys have begun to rise. The Index of Leading Economic Indicators has now risen for six months in a row. Productivity is up. And surveys indicate that consumer spending is up. GDP growth in the fourth quarter looks to be in the 3%-plus range.

All reasons to be bullish, if you are looking for a reason to be bullish. If you don’t examine the underlying data, you can feel good. The problem is that when we look deeper into the data than just the headlines, there are concerns.

For instance, take the contention that consumer spending is rising. I called Philippa Dunne at The Liscio Report. They survey the various states about taxes, among other things. “Sales taxes are not up and the current survey we are doing is pretty bad.” She used the word “horrified” when commenting on some of the respondees’ replies at the various state tax offices. Further, today we find that credit card lending dropped $17 billion last month, the largest drop in history. And this was during Christmas!

Savings are up. Credit is down. Where did the rise in consumer spending come from? Remember, these are mostly surveys and/or comparisons with a disastrous 2008. And they compare same-store sales for chains like Best Buy, which no longer competes with the bankrupt Circuit City, or for chains that closed stores, forcing buyers to the remaining stores. The key to watch is sales taxes. When they are rising, consumer spending is rising.

Consumer confidence is rising, but from truly awful levels. The levels are still well below any level in previous recessions and certainly do not indicate a robust economic rebound.

A challenged consumer confidence survey is not surprising, given the fact that roughly 8% of the working population is getting some form of unemployment assisance. One in eight children in this country is living on food stamps. By the way, the total number of people on unemployment is about 300,000 worse than most media accounts report. The Extended (and Emergency) unemployment claims for those out of work more than 26 weeks are not seasonally adjusted. To get the total number of people on unemployment insurance of all kinds, you have to add the non-seasonally adjusted number of continuing claims, which is currently about 300,000 higher than the seasonal adjustment. Here is a chart from Philippa, at www.theliscioreport.com.

She explained, “For the week ended 12/19, 10.42 million Americans were receiving unemployment benefits, With 5.44 million Extended claims (week ended 12/19) and 4.98 million Continuing claims.

“But NSA jobless claims show a far different story. The advance number of actual initial claims under state programs, unadjusted, totaled 645,571 in the week ending Jan. 2, an increase of 88,000 from the previous week. There were 731,958 Initial claims in the comparable week in 2009… The advance unadjusted number for persons claiming UI benefits in state programs totaled 5,479,110, an increase of 388,729 from the preceding week. A year earlier, the rate was 4.0 percent and the volume was 5,317,388.

“So the actual, the real benefits paid (Initial, Continuing, and EUC claims) hit another record of 11.268 million.” (source: The Big Picture)

Today’s employment report was just terrible. The headline said we lost 85,000 jobs. That is from the establishment survey, where they call up larger businesses and ask them about their employment. They also do a household survey, where they survey about 400,000 households. That report reveals a much worse situation.

Last month, single women who are heads of households saw their unemployment ranks rise by a massive 127,000. The number of employed men fell by 214,000. The total number of unemployed in the survey rose by an enormous 589,000. Those classified as not in the work force (due to the fact that they did not look for jobs) rose by 843,000! That now means that in 2009 3.5 million people were dropped from the potential labor force count because they were discouraged.

If you add those to the 15.3 million who are unemployed, you get a much higher unemployment number than 10%. Getting that exact number is tricky, because if you are back in school (as some of my friends are) you are not looking for a job but are going to want one soon. And if the economy does rebound and jobs start to become available, then it is likely a large number of the discouraged 3.5 million will start looking for jobs and therefore be listed in the work force. Ironically, a recovering economy could see the unemployment number rise. During the recovery, it will be important to look at the total number of employed and not just at the unemployment rate.

Sidebar: As noted above, a large number of people were dropped from the official labor force. What that means is that even though the number of employed people fell, the unemployment rate did not. It will be interesting to see if a lot of those people just decided that December was not a good time to be looking, spent time with families, or decided it was too cold to get out. How many will start looking as we get into the new year? We could see a rise in the unemployment rate next month if a large number do look for work.

Look at the chart below from my friend Greg Weldon. (It just hit my inbox.) It shows the percentage of people who are participating in the work force. (www.weldononline.com) It is sadly dropping, which means that incomes to families are dropping. The number of people I know who are looking for work or are struggling increases each week. It truly saddens me.

The Statistical Recovery

So why, if the employment picture looks so bad, are we getting positive GDP numbers? I coined the term “Statistical Recovery” last summer to describe an economy where the statistics are positive but it certainly doesn’t “feel” like a recovery. So, how is it that we see a rise in the statistics?

First, year-over-year comparisons are looking better, since 2008 was horrific. Second, inventory levels are about as low as they will go. In the way GDP is figured, a reduction in inventory reduces GDP. That was a negative figure for most of this recession. Simply because inventories not falling any more, it is easier to get a positive GDP.

Second, as I have written, there are one-time benefits for GDP from the federal stimulus. Roughly 90% of the 2.2% growth in GDP in the third quarter was attributable to the stimulus, and we will see a similar affect in the 4th-quarter numbers and at least through the first half of next year.

A reduction in imports is also a positive for GDP. Ee are buying less “stuff” from abroad, so that helps statistically.

Martin Feldstein, one of the great economists of our time, was quoted last week as saying that the recession is not over. Indeed, it you look at past recessions, it is not all that unusual (8 out of 11 times) for there to be positive GDP quarters in the midst of an ongoing recession.

The Great Experiment

So this is the backdrop as we look into the future. Unemployment is rising and is likely to remain stubbornly high (over 10%) for some time, except for the few months this coming summer when the Labor Department will hire hundreds of thousands of temporary census workers. The savings rate is rising, and consumer spending is at the very least challenged. The stimulus starts to drop sharply in the latter half of the year. States, counties, and cities are short about $260 billion and will either have to cut services (and thus jobs) or increase taxes. Housing is likely to get weaker, as there are large numbers of defaults coming because of mortgage-rate resets this year and next (more on that in a few weeks). Valuations on stocks are in the high range, and do not portend well for long-term returns.

Further – and this is the most important item to me – Congress is likely to allow the Bush tax cuts to expire and to add insult to injury with some form of large tax increase for heath care. Between the local, state, and federal tax increases, we could see a massive increase in taxes of perhaps $500 billion in a $13-trillion economy, or about 4% of GDP.

Think about that for a moment. It is likely we will begin 2011 with close to 10% unemployment, if not higher. Christina Romer’s work shows that tax cuts have a three-times benefit to GDP. Tax increases presumably have a similar negative effect. (Ms. Romer, by the way, is President Obama’s Chairwoman of the Council of Economic Advisers. This is not a partisan idea.)

This is the great experiment to which we are going to be subjected. There are those who agree with Art Laffer and company that tax cuts are a positive for the economy (that would include your humble analyst). And there are those who contend that the economy did just fine in the Clinton years before the Bush tax cuts and that we will do just as well if we take them away. And further, taxing the rich a little more is not really going to change their behavior.

My contention is that if such a tax increase is enacted all at once, the economy will at a minimum dip back into a nasty recession. If I am wrong, then I will have to abandon one of my long-cherished beliefs. I will have to stop arguing that tax cuts are as important as I think. Right now, when I read the data and studies, they confirm my tax-cutting bias. But I have to be willing to change my mind if The Great Experiment proves me wrong.

But if you think unemployment is high now, you will really not like what happens if we dip back into recession. It could go a lot higher. They are truly risking a great deal if they decide to pursue this experiment.

Thus, I am faced with a great deal of uncertainty as I look into the future with my forecasts – and we will get into the bulk of the actual forecasts next week. I almost titled this letter “The Year of Waiting,” because there are so many important developments we are waiting on. Will they actually raise taxes in such a soft economy, or will cooler heads prevail and the increases be postponed, or at least phased in over 4-5 years? What will the health-care bill look like? There are so many things that could significantly change any predictions.

As I have written for years, the stock market drops an average of over 40% during a recession. If we go into a recession in 2011, it is highly unlikely that there will be an exception to the bear market rule. But this market seemingly wants to go higher. Smart people like my partner Steve Blumenthal argue with me that the technicals say we could go a lot higher in the short term. And he may very well be (and probably is) right.

This is a trader’s market. It is not time to buy and hold large indexes or high-beta stocks and expect to be made whole over the next ten years. Hope is not a strategy. But waiting for the “shoe to drop” is frustrating, I know. However, that is the situation we find ourselves in.

We will go into this next week, but the current environment is quite different than 1982, when the last bull market started. Rates were falling; they are now likely to rise over time. Taxes were going down. Valuations were at historical lows, not high and rising. Inflation was coming down. And on and on. The current environment is not one in which bull markets are born.

Whither the Fed?

The futures market is pricing in rate hikes from the Fed beginning this fall. I highly doubt a politicized Fed will hike rates with unemployment over 10%, ahead of a November election. We are going to have a very easy monetary policy for longer than most observers think.

The Fed has painted itself into a very tough corner. Raising rates in a high-unemployment environment is risky. Bernanke knows what happened in 1937 and does not want a repeat. But by keeping rates too low for too long, they risk an asset bubble or two. And the federal fiscal deficit of over $1.5 trillion is not making their situation any easier.

The Fed has announced it is ending many of their various and sundry programs in the first quarter. They have essentially been the mortgage market. What will happen to rates? I think that is one of the reasons why Geithner has essentially lifted any limit on explicit guarantees for Fannie and Freddie. It will be seen as higher-paying government debt. It will also cost you, Mr. and Ms. Taxpayer, hundreds of billions in increased deficits, as they are telling those entities to eat the losses from large numbers of loan modifications. This is outrageous on so many levels. Congress should at least have to approve this.

It’s getting close to my eight pages, so let me end by saying that, as we face the next crisis – and we will (there is always another crisis) – we will find we have not fixed the causes of the last one. We still have banks too big to fail, we have not put the credit default swaps on an exchange, we have not reinstated Glass-Steagall, Barney Frank’s bill (which was not the one that came out of committee) now makes it exceedingly more difficult to short stocks, we keep in power the same people who missed the problems the last time, and the list of bad policies bought (typo intended) to you by bank lobbyists grows ever longer. If the current bill looks like it was written by the bank lobby, that’s because it was. But it means we will have to face the same problems all over again. But that is another story for another day. Next week we look at the dollar and other currencies, gold, commodities, bonds, emerging markets, and more.

Your more optimistic than this letter sounds analyst,

John Mauldin

This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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Given the widespread expectation for future inflation, and as an extension higher interest rates to combat rising prices, the question above is the most common one we hear from home buyers and real estate investors alike. To try and resolve the issue to completion on this short page would be ambitious, to say the least.

(click to enlarge image)

During the inflationary period of the late seventies and early eighties (flip back to pg 5 for a picture of
inflation during this period), mortgage rates climbed to almost 20%. In a world where locking in a rate north of 5% feels like a rip-off, 20% mortgages are a thing of fantasy.

Yet, despite this seemingly gale force headwind, home prices still climbed. While there are number of reasons for this increase (demographic, regulatory, etc), let’s focus on one in particular: Inflation Expectations.

Thumb through speeches written by pointy-headed Fed economists and you’ll find this phrase, “Inflation Expectations” peppered throughout discussions of monetary policy and the fear of rising prices. This is one of the least appreciated, yet most important aspects of effective use of monetary policy to manage inflation.

At the core, all economic decisions reflect participants’ view of the future. Specifically, buyers consider what utility (ie, use) they can receive and whether the price for that utility is fair. Embedded within this decision is some expectation of what can be done with that money in the future: Saved, spent, invested, etc.

When consumers fear rising prices, that a gallon of gas will cost more tomorrow than it does today, they buy the gas today. This pushes future demand forward, increasing aggregate demand and in turn, prices. The cycle continues, and in extreme cases (think Zimbabwe or the Weimar Republic), hyperinflation ensues.

As inflation rises, so too do Inflation Expectations. Consumers deploy capital towards assets they perceive to be a better store of value than the worthless paper in their pockets. They buy gold, they buy oil, they buy real estate. So, even with higher rates, money still flows into housing.

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