Saturday, April 30, 2005

The road to a bubble?

Why the bubble willl burst?

1) Higher Interest Rates : As Interest rates rise, home owners who are already deep in debt are going to find it even more difficult to pay higher monthly payments. Most sectors of the economy are not growing, leading to falling wages and increasing costs of education, healthcare and rising prices. Squeezed between falling wages and rising interest rates, may owners will walk away from their homes. In the absence of higher incomes, home prices will have to fall, inorder to accomodate the rise in interest rates.

2) Record levels of debt : The nation and the individuals carry a mountain of debt, in the form of deficits and low savings rates. Hence most of the home purchases are being made due to easy credit. When the interest rates increase, the foreclosures are bound to increase and this is going to be a quick downward spiral.

3) Low savings rate : Home buyers are mortgaged to the hilt. The US Savings rate is currently at 0.2% and is at the lowest in many decades. A significant portion of these homes have been purchased on credit. Further, many buyers have sought loans even to pay the down payment. If the interest rates were to rise, it would be difficult for many home owners to keep up with the rise in payments.

4) Poor economy : Enough said. Between the rising trade deficit, the budget deficit and the loss of jobs, we have seen the number of jobless rise over the past five years. Further any decrease in number of unemployment benefit claims is not due to people finding work, but due to their giving up hope and stop looking for work altogether.

5) Rental rates vs House prices : If there were really a shortage of housing, then we should be seeing a shortage of rental properties. Rental rates should be increasing and the rental vacancies must go down. However, the rental vacancy rate is currently at 10%, the highest since the Census Bureau started tracking the data in the 50's.

6) Record unemployment : While statistics have you believe that the number of workers seeking unemployment benefits is dropping, that is happening due to workers losing their eligiblity to draw down further unemployment benefits. With several millions of jobs transferred overseas and several hundreds of thousands of jobs permanently lost after the dot com bust, it is almost impossible for the employment situation to be what it was, a few years ago.

7) Subprime lending : Banks and financial institutions are more than happy to dole out loans, without regard to the repayment capabilities or credit status of the borrower. Zero down loans, 125% loans, Interest only loans, ARMs and other financing schemes are now at their historical highs and many borrowers are going to be squeezed as the interest rates rise and the payment comes due. This will ultimately affect not only the borrowers and their communities, but the ripple effects will be felt throughout the society.

8) Boomers entering retirement : The baby boomer generation has begun retiring. With outsourcing, weak job prospects and insufficient income from social security, they will be forced to cash in, what constitutes the only asset for most - their house. While boomers who cash in early on may be able to get a good price, other sellers may end up listing their houses during periods of surplus inventory, thereby further dragging down house prices tremendously.

9) Changes to bankcruptcy laws : The recent changes in bankruptcy laws will make it very difficult for those with credit problems to retain their homes. As a result, bank reposessions will rise and these foreclosures will flood the markets, thereby lowering prices drastically.


1) The bubble is regional : False. Nationwide, prices have risen 52% since 1990. While some of the metros such as Seattle or Boston may have risen more than certain other inland cities, almost all areas have seen a price increase. If the rise in prices is nation wide, there is no reason to believe that any deflation will be limited to a small region. Several analysts and central bankers who say that any housing bubble is regional fail to remember that during the tech bubble, the stocks of almost every company rose in price. Subsequently after the crash, the entire economy went into a recession. Hence it would be unwise to hope that only Los Angeles, Boston, Seattle, San Francisco etc.. would bear the brunt of a crash and the rest of the market will be unscathed.

2) Limited land : Most people believe that a CEO and his board could print stock certificates out of thin air and sell them to the gullible public and that unlike stock, the supply of land is limited. While the supply of land is limited, there is ample land in most areas (except in the downtown areas), for most people. Unless you are in London or Los Angeles or Manhattan or similar extremely crowded areas, land is almost always available in the suburbs or within a few miles of the city. There is no reason, why houses in areas very far from the city, should command astronomical prices. Besides land is scarce in Japan too, that has not prevented real estate prices from sliding downwards further, every year for the last 15 years.

3) The amount of land is shrinking due to environmental regulations : A large portion of the rise in house prices took place between 2000 and 2005, during the term of an administration that would rather be caught dead, than enforce environmental laws.

4) Immigrants : Despite popular belief, facts do not support the myth that recent immigrants are responsible for the housing boom. Most immigrants work for years and try to get their immigration details sorted out, before they plan to buy a house (if they can afford to buy one, that is...)

5) For the housing market to collapse, there should be a large external stimulus or shock : False. The collapse can be kicked off by fairly small events. All it takes, is one seller in a single block to sell his/her home below what is widely propagated as the market value and the domino effect is set into motion.

6) Housing market will collapse, only if the interest rates rise and rise suddenly : During the last housing bust in Los Angeles, CA, the interest rates were on a downward trend. The real estate crash in Japan occured, when the interest rates were near bottom.

7) Home prices are based on supply and demand : True and False. While home prices are based on supply and demand, the demand part is overhyped. The various realtors, mortgage bankers etc. woulld like you to believe that the reason a shortage of supply is causing rise in prices. However, if you look at the balance sheets of most home builders, you will note an increase in unsold inventories. Check out the balance sheets of your favorite home builder from 2002 though the latest statement and you will be suprised to see an increase of almost 110% in some cases!

8) Everyone needs a roof over their head : True and False. Everyone needs a roof over head, but the roof does not have to be their own. A few people choose to own the house, while others may choose to rent. However, over the last year, a record number of people are buying homes, with the intention to flip. These speculators are not buying, a home because they need a place to stay. Rather they are looking for the next sucker to unload to.

Why the bubble may not burst

1) Overzealous administration : The administration may be willing to pour in more money to keep the bubble going, as this may potentially be the only legacy of this administration and could turn out to be an election issue for Jeb Bush.

2) Greenspan : With Alan Greenspan in his last term, he would like to leave on a high note, rather than have two-thirds of the population think that he was responsible for the utter collapse in their standard of living. Further as soothsayer of the economy, it is in his interest to talk up things than to reaffirm the underlying grim picture.

3) Trade deficit : Foreign nations continue to buy our bonds, because their chief economists may be under the misguided notion, that it is better to finance our debt than to lose us as their primary market.

What are the signs to look for? (based on previous bubbles)

1) Old homes are on the market longer
2) Home builders offer free upgrades
3) Home builders quietly offer discounts to select buyers
4) Home builders hold "closeout events"
5) Quality of earnings (profits) decline
6) Revenues decline
7) Prices are in a downward spiral until they reach 40-50% below their current levels
8) Foreclosure rate rises
9) Number of personal bankruptcies rise
10) There is a pressure on the prices of homes at the high end
11) There is a pressure on the pricces of homes at the low end
12) Number of new home permits issued, begins to decrease.
13) Revenues at home improvement stores, begin to trend downwards on an year over year basis
14) Decline in employment in the construction industry
15) Decline in number of homes sold, will precede the drop in prices of the homes in that area.
16) Reduced consumer spending. You can get this data, from earnings reports from the various retailers. Thanksgiving and Christmas sales are a good indicator, of how the year was, to the consumer and the society.
17) Significant increase in use of interest only ARMs and other risky credit schemes, that could land the borrower in trouble, should interest rates rise significantly
18) Consumers find it increasingly difficult to tap into their home equity lines of credit, for other purchases.
19) Mortgage insurance companies tend to increase premiums on PMI for borrowers with multiple homes or those borrowers whose underlying motive may be to flip the property for a quick profit.

Sunday, April 24, 2005

Wanna buy this house? Send your résumé.

| Contributor to The Christian Science Monitor
A headshot and bio is standard protocol to get an audition for a TV show or a play. But are they really necessary to buy a house?

They are in some neighborhoods of Los Angeles where, in addition to offering as much as $75,000 over the asking price, buyers are sending flowery bios, pictures, and letters to sellers.

"I just oohed and ahhed my way from room to room," read one letter to Jane Centofante, who was selling her 2,000 square-foot home in Westwood, a tony L.A. suburb, for a cool $1.49 million. "I gather from your [house] that you are warm and smart and bring incredibly beautiful detail to your world," read another. Ms. Centofante was stuck - deciding between the family who included a photo with their dog and the young screenwriter who wrote a flattering two-page letter - when other events put the sale on hold.

Welcome to America's frothy real estate market, where in some places enthusiasm and excess have reached a point that, to many, seems eerily similar to the dotcom craze of the late 1990s.

Of course, housing prices don't rise and fall like stock prices. They move more slowly and because of different dynamics. Still, it's hard to imagine the intensity of today's market continuing indefinitely, experts say.

"There is a conceptual limit that we have gone beyond," says Susan Wachter, professor of real estate and finance at the University of Pennsylvania's Wharton School. "And we are more vulnerable to price volatility. But complicating the issue is that there is no simple measure of a bubble."

Instead, there are anecdotes that would have seemed unbelievable 10 years ago. For example:

• Bidding wars in California are forcing real estate agents to write recommendations on behalf of their clients who are attempting to buy a new home.

• Real estate trade groups in Massachusetts are calling on state officials to approve more housing construction to improve prospects for buyers.

• Retirees moving to Florida are living in hotels for weeks and even months at a time as they scour the state in search of affordable places to live.

Most baffling to economists, and even those who reject the notion of a bubble, is that the supply of homes for sale continues to dwindle in places like Florida, southern California, and Massachusetts. Thus, there is no clear sign that the real estate market has peaked. All of these places experienced double-digit increases in home prices throughout 2004, some repeating their cloud-piercing performance for the third consecutive year.

Big gain in one year

In February, the median price of a home in Florida rose 25 percent to $201,400 when compared with the same month a year ago. The West Palm Beach-Boca Raton area of the state continues to register the biggest leaps in home prices, climbing as high as 34 percent in the fourth quarter of 2004.

Multiple bids keep coming through, says Marilyn Jacobs, who sells homes in Boca. And more often than not, her sellers are rejecting a lot of people.

"They've had to kiss a lot of frogs before they find their prince," says Ms. Jacobson, a native New Yorker. "But those other frogs will find their palaces, too. There are still plenty of opportunities."

Not so in Massachusetts. The state has seen a precipitous drop in housing construction, keeping demand taut and prices aloft. The conditions have worsened in three years, evoking a theme akin to the late 1980s.

At that time, housing prices throughout Massachusetts were appreciating rapidly and they didn't correlate with the annual rent a house could command - a relationship economists scrutinize to detect a bubble. The result: a real estate recession that knocked prices down and drove investors away from the housing market.

Despite the evidence, "I don't believe there is a bubble right now,'' says Maggie Tomkiewicz, president of the Massachusetts Association of Realtors, who argues that today's supply-and-demand conditions don't contribute to a real estate bubble. Interest rates were also trending downward in the late 1980s.

Effect of interest rates

But economists today are forecasting that interest rates will rise, a notable characteristic of a cooling trend for the real estate market. The danger is that until interest rates rise, home buyers will continue to snap up real estate they can't even afford. Zero percent down and 100 percent financing are influencing many homeowners to live beyond their means.

"It's like you have all of these people driving around in fancy cars and drinking expensive wine because they feel rich,'' says Christopher Thornberg, a senior economist with the University of California at Los Angeles Anderson Forecast. "The problem is there is all of this money floating around and something has to break.''

Mr. Thornberg's prognosis: "The whole US is in a bubble right now. And it could go on for another year.''

Or burst in the next six months, according to Harvey Dent Jr., author of "The Next Great Bubble Boom." He bases his prediction on a recent estimate from the National Association of Realtors that 23 percent of last year's home sales were second homes purchased by investors.

That made sense when real estate proved a better investment than poor performing stocks. But as interest rates rise, Mr. Dent says, they will push investors out of real estate and back into stocks or bonds. "That's why I'm renting an apartment in Miami Beach," Dent says. "I don't want to get stuck owning some overvalued piece of property."

Delay in the deal

Unfortunately, Jane Centofante has yet to sell her home in Los Angeles. An inspector found traces of creosote - a mixture of potentially toxic chemicals - throughout her home. Since the finding, she has lost four potential buyers during escrow, that critical period of time when a buyer and seller work out the money and other requests when transferring ownership of a home.

"I'm ready to sell. And I want to sell. But now I can't," says Centofante, who hopes to have the creosote problem remedied before the market sours.

Housing Experts Wary of Bubble Fatigue

By Ilaina Jonas

NEW YORK (Reuters) - Bubble or not, the U.S. housing market has stayed afloat at a high altitude for the past two years.

So what do experts look for as the first signs of fatigue in a frothy housing market?

Mark Zandi, chief economist for, said it won't be buyers who will disappear. Instead, he believes disgruntled sellers will bring the market to a halt.

"People will start pulling their homes off the market if they think they can't sell it at a 'fair price,' which is now perceived to be a very high price," he said.

While debates about whether the robust housing market will burst like a bubble or land like a slowly deflating balloon dominate discussions everywhere -- from think tanks to cocktail parties -- most agree that what goes up must come down.

"You'll see transactions fall off very rapidly," Zandi said. "It's not that prices are coming down. It's that there's nothing selling. The first piece of data where you get a sense of that is not home sales. It's mortgage applications."

If applications fall, particularly in periods where interest rates rise, a housing freeze is likely to arrive.

"That would indicate to me after a week or two (of lower mortgage applications) that something fundamental is going on in these markets," he said.

According to the Mortgage Bankers Association's latest survey, applications for U.S. home mortgages decreased last week. Its seasonally adjusted index of mortgage application activity fell 1.6 percent to 672.6 in the week ended April 15.

The dip in mortgage applications came despite a drop in fixed mortgage rates, which some analysts believe is an indication of waning housing demand.

Fixed 30-year mortgage rates averaged 5.83 percent last week, excluding fees, down 12 basis points from 5.95 percent the previous week, according to the MBA.


Douglas Duncan, chief economist at the Mortgage Bankers Association, believes the biggest factor that will drive a decline in housing demand will be interest-rate changes, particularly a sharp shift higher.

"Rates have been so low for so long. But if the 30-year fixed-rate mortgage rate passed the 7 percent mark any time soon, we may see a pause in housing," he said.

Zandi and Duncan are in the camp of those who believe that there is a housing bubble in certain markets that are "infected" by speculative buyers. These are markets in which buyers have no intention of living in the house. Instead, they plan to quickly sell the property and reap the benefits of rapidly rising housing prices.

An increase in aggressive borrowing, practiced by those who look for interest-only or variable-rate loans, also would signal a housing bubble about ready to burst, those in the bubble camp said.

The housing bubbles exist in California, the Pacific Northwest, parts of the Mountain West, all of Florida and along the East Coast from Boston to Washington D.C.

"Bubbles don't pop overnight," Zandi said. "They continue to build for long periods of time. Look at our experience with the stock market. We were worried about a stock market bubble for over three years before it actually burst."

Others look at not so conventional signs.

"When developers start talking about a housing bubble bursting," said one New York developer, who did not want to be identified, "that's when you have one."

Van Davis, chief executive of Foxtons North America, is in the other camp that believes there is no bubble. He said that yes, housing prices will go down, but the demographic demand from immigrants and children of aging baby boomers, will rule out the bubble-and-bust scenario.

"California has been frothy over the past 18 months," Davis said. "I hear things are cooling down significantly."

Davis keeps an eye on inventory -- measured in the amount of time it would take to sell the current number of homes available -- to gauge the market. Right now, it would take about 4.2 to 4.3 months to clear the current inventory.

"By any historic measure, a balanced market is six months," he said.

During the tough real estate times from about 1988 to 1993, inventory levels approached 13 months.

The Housing Bubble

Are we experiencing a housing bubble? That’s the million dollar question being asked by most homeowners today. Here is the evidence that we are in a massive housing bubble:

At first look, housing and real estate are performing spectacularly. Since 1980, the average home is up by 185 percent. In recent years, despite the recession, housing prices have risen by over 43 percent. To put that into perspective, in last 5 years, the average house-hold net worth inflated by $75,000. In California during 2002, the average house-hold soared by $3,000 per month!

Housing Bubble Chart

The rapidly rising housing prices are the main sign that we are in a massive housing bubble. Housing bubbles occur when housing prices overheat as they skyrocket, only to come crashing down for at least a decade to come.

What is Fueling the Housing Bubble?

This answer is the simplest: Mortgage rates are at a 40-year low. In 1982 mortgage rates were at a lofty 16 percent and have been dropping steadily to about 5 percent! When mortgage rates drop, monthly mortgage payments decrease as well. This decrease makes housing more affordable, which in turn triggers a bull market in housing prices.

Mortgage rates won’t stay low forever as this low rate environment can’t be maintained for much longer. When rates do rise, housing prices will fall as prospective home buyers will be discouraged by higher monthly mortgage payments.

A major sign that we are in a housing bubble is the fact that fewer people can afford homes. Housing prices have been rising at a vastly higher rate than incomes. Now more people are unable to afford the average home in their town. A housing bubble needs a steady stream of thirsty home buyers. If housing is significantly less affordable, then who is left to keep buying to prop up home values? No one! Overheated real estate prices are going to collapse plain and simple. This is just a real life example of supply and demand.

The Borrowing Binge

As interest rates have dropped, and housing prices soared, homeowners have found gold in home equity credit lines. These credit lines are a way for homeowners to borrow large sums of money backed by their home’s equity. Sort of like a credit card, but in the form of a house. Basically, these credit lines increase the amount of mortgage the homeowner owes.

To make matters worse, 51 percent of this borrowed money is being spent on home improvements and consumer items. Now you can see why $70,000+ luxury car market is booming!

Home equity has diminished significantly as we are consuming our free cash rather than paying off our mortgages. Simply stated, frivolous consumers are maxed out on credit. Since 1995 national mortgage debt has risen from $4 trillion to $7 trillion! In just 2002, $820 billion was borrowed! If this isn’t a sign of a housing bubble, than I don’t know what is.

The United States, as a whole, is in debt by $32 trillion, of which the majority was added in the borrowing binge of the 1990’s. The economy is so debt-ridden that we are now similar to a house of cards. It won’t take much to topple this ever inflating housing bubble.

The housing bubble will start to deflate when interest rates rise. Furthermore, even a slight downturn in our already feeble economy will cause an increase in mortgage delinquencies as consumers buckle from their debts. Of course when this happens, credit card defaults will also rise as will personal bankruptcies.

After the Housing Bubble Pops

After the housing bubble pops, prices will likely plummet for at least a decade, unfortunately. Too pessimistic? Consider this: After the 1989 Japanese housing bubble, housing prices tanked for 13 straight years! The Japanese housing bubble was a similar situation to what we are currently experiencing.

Even if the housing crash isn’t nearly as drastic, it could still take at least 9 years to recover. This is precisely what occurred after 1988 as the United States housing boom ended. National housing prices finally reached previous 1988 levels in 1997!

From what we have seen, it is inevitable that we are in a housing bubble that will end in an economic crisis. The economy always finds a way to punish excess.

Possible market bubbles abound

Could it be U.S. housing, commodities, China's economy?

Special to The Morning Call

With the benefit of hindsight, reasonable people today agree that technology stocks in the late 1990s became a monumental financial bubble.

Five years from now, what will the reasonable people of 2010 recall as the great bubble of 2005?

Or will they have trouble picking just one?

The housing market has become the most discussed candidate for bubble-hood this year. But unlike in 2000, when the dot-com mania had no market peers, housing today has some stiff competition on the financial gasp-o-meter.

The commodities market, led by oil, has had many of the earmarks of a bubble — not least a near-vertical ascent in prices until recently.

The booming Chinese economy has been slapped with the bubble label. The record U.S. trade deficit, partly an effect of China's boom, also looks bubbly in the sense that economists say it can't keep growing, yet it does.

Some Wall Street veterans say the global bond and mortgage markets may constitute the scariest bubble of all, as investors and lenders have fallen over themselves to extend credit to companies and individuals at generously low rates of interest. The creditors may come to regret their largess if the economy slows and many borrowers suddenly can't pay their bills.

Given that each of the aforementioned bubble candidates can be linked to one another with less effort than a game of Six Degrees of Kevin Bacon, it might be reasonable to suppose that they aren't individual bubbles but rather one mega-bubble — the totality of the economic and financial world we live in.

It isn't a pretty thought, of course, because the common denominator of all financial bubbles is that they create huge messes when they burst.

Recall the hundreds of billions of dollars in retirement savings lost by hardworking people when the technology bubble exploded during 2000-02. Then imagine the potential financial harm if, simultaneously, housing values went the way of tech stocks, China halted its massive buying of U.S. Treasury bonds (which has helped finance our budget deficit and kept U.S. interest rates down) and corporate lenders found that too many of their debtors really didn't deserve credit, or at least not on such benevolent terms.

The concept of a mega-bubble and its collapse is an accommodatingly depressing scenario for people who pine for the end of the world. It also may be a fiction borne of peoples' natural tendency to relate the present to the recent past, and assume that history must repeat.

Barry Ritholtz, market strategist at brokerage Maxim Group in New York, says the severity of the tech stock bust has left many investors seeing its ghost everywhere. The result, he said, is that ''we have a bubble in bubbles'': Any market that has big numbers attached to it becomes a candidate for bubble-hood.

As Ritholtz points out, however, ''being overpriced is not the same as being a bubble.'' In a capitalist system, investment values are forever moving from underpriced to fairly priced to overpriced and back. That's the nature of free markets.

But true bubbles on the scale of dot-coms in the late 1990s, or Japanese stocks in 1988-89, or tulip bulbs in 1636-40, are relative rarities.

The dictionary definition of ''bubble,'' in the financial context, may be helpful here: ''any idea that seems plausible at first but quickly shows itself to be worthless or misleading.''

Home prices may be inflated, particularly on both U.S. coasts, but there is some value in every livable house. Likewise, a barrel of oil has some worth, because it's good for something — it can power your car.

A barrel of tulips, by contrast, isn't very useful today, and probably wasn't in 1640 either.

Jeremy Grantham, chairman of money manager Grantham, Mayo, Van Otterloo & Co. in Boston, allows that a durable wooden roof over your head has more value than, say, a piece of cardboard papered with dot-com stock certificates.

But he counts himself as more worried about a financial mega-bubble than many of his peers on Wall Street.

Grantham contends that most stocks and bonds, and many residential real-estate markets, are far overvalued and must decline substantially in price by the end of this decade.

He believes the blue-chip Standard & Poor's 500 stock index should fall to about 730 to be ''fairly valued.'' That would be a drop of about 35 percent from Friday's closing level. And yields on high-risk corporate bonds should be significantly above current levels, by his estimation.

Grantham also concedes that he has been predicting a financial unraveling for the last two years and has been dead wrong. ''We were horribly early,'' he said.

But his reasoning hasn't changed, Grantham said: The Federal Reserve, by cutting interest rates to generational lows in recent years, inflated a new crop of financial market bubbles by giving investors the wherewithal to aggressively bid up the values of bonds, real estate and (once again) stocks, he said. That's what easy money will do, and that's what it did, in his view.

The Fed ''tried to get us off the hook from the stock bubble [of 2000], and as a consequence a lot of other assets became more expensive,'' Grantham said.

With the Fed now tightening credit, it is taking away the source of asset inflation, he said. That makes it more logical to assume that prices of those assets are headed lower rather than higher, especially given how high prices have risen, he said.

It's a simple premise, and perhaps too simple for a complex global marketplace in which investors often aren't bound by logic, or by one man's opinion.

What we know about bubbles is that when you're inside them, it's often hard to recognize that fact. The people of 2010 may have to make that judgment for us.

Tom Petruno is a reporter for the Los Angeles Times, a Tribune Publishing newspaper.

Home prices soar while rents barely budge

In San Diego County, owning a home is more than the American dream. It's considered the ticket to financial security, the great dividing factor between haves and have-nots. It's an article of faith that home ownership is better than gold: homes provide a place to live and an investment that's surer to gain value than buying into the risky stock market.

Believers in that faith have been amply rewarded in the last decade. While the stock market has risen and crashed, home prices have gone in one direction ---- up. Double digit annual increases in housing prices have become normal. In the last few years, those who have warned about a real estate bubble have been seemingly disproved with each new month's report.

But in the last few years, something strange has happened. While the cost of buying a home in San Diego County has soared, rental costs have barely kept pace with inflation. Although rental costs are still going up, the increases have been progressively smaller. That's a red flag to some real estate experts, who say it's a sign the real estate market is out of whack ---- and that home prices are unsustainably high.

It's not possible, of course, to compare directly home ownership and renting. And local real estate experts stress the special character of San Diego County's real estate market, which has defied expectations before.

However, the costs of renting and housing historically have moved in the same direction, because both are driven by supply and demand. So a widening gap between the monthly cost of renting and a mortgage indicates a real estate market out of whack, say experts who warn of a bubble.

Fall ahead?

Robert J. Shiller, a professor of economics at Yale University, cites one eye-opening statistic that implies San Diego's double-digit price increases are an anomaly. In a new edition of his book, "Irrational Exuberance," Shiller has calculated that since the 1880s, home prices nationwide, when adjusted for inflation, have increased by just 0.4 percent a year.

Shiller's book, as the title implies, was written to warn about the dangers of stock mania. It was published at a timely moment in early 2000, just before the stock bubble burst. Now he warns in an updated edition that real estate is in one now.

Shiller's warning is reinforced by a survey from Torto Wheaton Research, a Boston-based business unit of CB Richard Ellis. San Diego's rent/ownership cost disparity, which has increased substantially over the last four years, is now the greatest of the 21 metropolitan markets the company surveyed.

The average monthly cost of renting in the county in 2004 was just 40 percent of an average monthly mortgage, according to the Torto Wheaton survey. That percentage is down from 57 percent in 2000. Nationwide, the ratio was 92 percent, compared to 95 percent in 2000.

The average price of a home in San Diego County was $269,000 in 2000 and $552,000 in 2004, an increase of 105 percent. Meanwhile. Rents rose from $1,027 in 2000 to $1,177 in 2005, an increase of just 15 percent.

Such an increasing disparity obviously can't go on indefinitely. The only question is when it will stop.

There are three possibilities, said Gleb Nechayev, a senior economist at Torto Wheaton who conducted the survey. One is that rents start to rise more rapidly. The other is that home prices will stagnate or even fall. The third is that both will happen.

Nechayev said the second option is most likely.

"By 2006 or 2007, we should see the beginning of a slowdown in home prices" in San Diego, Nechayev said.

Depending on what happens with interest rates and the economy, the slowdown could take the form of five or six years of flat prices, Nechayev said. That's the more painful possibility, Nechayev said. Alternatively, home prices could actually fall briefly, allowing price appreciation to begin again at a more sustainable level.

Nechayev projects that San Diego County rents will stay nearly flat. Increasing by an inflation-adjusted 1 percent per year for the next five years.

"With all the new construction, as well as condos being purchased for investment purposes, there will be some saturation on the supply side, and that will be affecting rent growth to some degree," Nechayev said.

A special market

This analysis is disputed by many local real estate experts. They say San Diego County has such a long-term housing deficit and dwindling supply of unused developable land that it is in no danger of saturation.

"I really don't see (housing) prices going into the tank," said Diane Miramontes, an investment specialist with Grubb & Ellis BRE Commercial. "This is Southern California and San Diego, a unique animal. ... We've got Mexico on the south, ocean on the west and Camp Pendleton on the north."

As long as the economy holds up and people can afford to buy, there's no reason to expect the real estate market to slump, Miramontes said.

Carlton Lund, a broker and agent with Prudential California Realty in Carlsbad, said some sellers still have unrealistic expectations. While he doesn't forecast a collapse in prices, Lund cautions that it's no longer possible for sellers to look at comparable recent transactions and automatically slap on a premium. He worries that sellers with that attitude are setting themselves up for a big disappointment.

It's still possible to get those hefty prices, Lund said, but it takes a lot of work, and the property must be special. One home he recently sold, at the southeast corner of Pacific and Tyson streets in Oceanside, brought an eye-popping $2.77 million.

But that massive home, adjacent to the beach with a magnificent ocean view, had been recently rebuilt almost from the ground up. It took a year to sell, Lund said, and had actually been taken off the market for a time.

Rents to increase?

Another way to narrow the gap ---- besides falling home prices ---- is for rental prices to increase more rapidly. Miramontes, who specializes in selling apartment complexes, said this is likely to happen over the long term. People who want to live in San Diego County who can't buy a home will rent, she said, and that demand will drive up rental prices.

However, Miramontes said, landlords have different philosophies and financial needs when it comes to setting rent prices.

Landlords with relatively new properties need to charge more than landlords with older properties that have already been paid off, Miramontes said. And some landlords stress getting the last possible dollar, while others think it's more important to minimize the hassle and expense of losing tenants when rents increase.

"It just depends on theories of management," said Darcy Miramontes, who works with her mother. "Some people are very aggressive ..."

"... and some people not at all," Diane Miramontes said, completing her daughter's thought.

Condominium conversions, increasingly popular in San Diego, are not much of a factor in rent prices, Nechayev said, because they only amount to a small fraction of rental units.

Since September, 2,800 rental units have been converted into condominiums, according to a March report from MarketPointe Realty Advisors. However the report stated that this amounts to only 2.5 percent of the rental housing stock.

In addition, many of the new condominium units are purchased by the renters, Nechayev said, removing them from the rental market.

Owners as landlords

Last week, the San Francisco-based research firm RealFacts released a survey that found rental prices "listless" throughout the West, and barely keeping up with inflation in San Diego. In addition, the survey stated there's not much rental construction going on in San Diego or elsewhere in the West, because it's more profitable to build condos and single-family homes.

New apartment construction, when it occurs, tends to be high-end, the survey said. One local example of new high-end rentals added to North County is Monarch at Shadowridge, a high-end development of 314 units that resembles an upscale condominium community. Rents for one-bedroom apartments start at $1,275 a month, two-bedrooms for $1,700 a month and up, and three-bedrooms start at $2,275 a month.

These facts don't easily fit together. All else being equal, economic theory predicts that if rental construction is slowing down, rents should rise as the population grows. San Diego's economy remains strong, with a March unemployment rate of 4.3 percent according to the California Employment Development Department.

There is an explanation that resolves the "disconnect" between soaring home prices and stagnant rents, said Gerald P. Cox, RealFact's marketing director. If a substantial proportion of home buyers are investors who don't live in their homes, they rent them out to repay the mortgage. Cox said he does not know if this explanation is correct.

But if it is, he said, demand for homes for sale would be artificially increased over normal demand, boosting prices. However, rental prices could not increase so rapidly, because there is not a corresponding increase in rental demand. Indeed, the homes would add to the existing stock of rental units.

While the buyers will try to charge enough in rent to cover their mortgage, Cox said they can't set their price above the going rate.

"The local market will set what the rental price is," Cox said.

Friday, April 22, 2005

America's Housing Boom: Is The Bubble Due To Pop?


Real estate-crazed Americans have started behaving in ways that eerily recall the stock market obsession of the late 1990s.

In a version of day trading, some houses Naples, Fla., have been bought twice in a single day. Buying stocks on margin has morphed into buying homes with no money down. The over-the-top parties of Internet startups have been replaced by flashy gatherings where developers pitch condos to eager buyers.

Five years ago, the cable channel CNBC sometimes seemed like a backdrop to daily American life. Its cheery analysis of the stock market played in offices, in barbershops, even in some bars. Today, “Dude Room,” “Toolbelt Diva” and other home-improvement shows are the addictive fare that CNBC's exuberant stock shows once were.

“It just seems like everyone is doing it,” Laurie Romano, a 26-year-old self-described real estate investor, said with a giggle as she explained why she was attending an open house this month for the Nexus, a 56-unit building going up in Brooklyn's chic Dumbo neighborhood. She and her fiance, a dentist, had already put down a deposit on a Manhattan condo earlier in the week and had come to look at another at the Nexus.

Raising alarms

Nobody can know whether the housing boom of the last decade will end as the dot-com frenzy did. But the parallels are raising alarms among many economists, even those who acknowledge that there are important differences between homes and stocks that significantly reduce chances of another meltdown. For one thing, houses are not just paper wealth: You can live in them.

Perhaps the most troubling similarity, some analysts say, is the claim that the rules have somehow changed. In an echo of the “new economy” investors' blase attitude toward unprofitable companies, the growing ranks of real estate investors are buying houses they never expect to be able to rent at a profit. Instead, they think the prices of houses will just keep rising.

Indeed, the government reported Thursday that sales of new homes jumped sharply in February in the biggest monthly increase in four years. A strong economy and an improving job market contributed to the gain, as did speculative fever. But many were also trying to beat rising mortgage rates, which could eventually cool the market.

Robert J. Shiller _ a professor of economics at Yale whose prescient book on stocks, “Irrational Exuberance,” appeared just a few months before technology stocks began their slide _ has returned as a doomsayer on the housing market.

“We're going through something very similar in real estate that we did with stocks,” he said. “It's driven by the same forces: that investments can't go bad, that it has the potential to make you rich, that you'll regret it if you don't do it, that it looks expensive but is really not.”

A new edition of Shiller's book will be published next month. The cover promises an “analysis of the worldwide real estate bubble and its aftermath.”

Premonitions of a bubble on the verge of popping do not ruffle those who are bullish on real estate. In Miami, Ron Shuffield, president of Esslinger-Wooten-Maxwell Realtors, predicted that a limited supply of land coupled with demand from baby boomers and foreigners would prolong the boom indefinitely.

“South Florida,” he said, “is working off of a totally new economic model than any of us have ever experienced in the past.”

The can't-miss aura has helped nudge many families to invest more of their personal wealth in real estate by buying more expensive homes and taking on riskier mortgages — much as ordinary workers used their 401(k) plans to bet on company stocks.

There are certainly serious reasons to believe that house prices will not suffer the fate of technology stocks. Not only are houses more tangible, but people do not sell their homes as quickly as stocks, making a panic much less likely. And because of tax advantages, few owners are likely to sell and rent something else simply because local house prices start to decline.

And as high as they might seem now on the coasts, home prices have not even doubled over the last decade; during the 1990s, the Standard & Poor's 500-stock index more than quadrupled.

“I just don't think we have what it takes to prick the bubble,” said Diane C. Swonk, chief economist at Mesirow Financial in Chicago. “I don't think prices are going to fall, and I don't think they're even going to be flat.”

Such optimism about real estate has created a stampede of new investors. The night before the Nexus party, Patrick Cullert, 31, and Jennifer Mathews, 29, who are engaged, camped out to ensure they would be near the head of the line for one of 16 condos to be sold at the party.

Many former stock market enthusiasts are turning to housing. Douglas Paul, a 46-year-old former analyst, left AT&T in 2002 to buy and sell stocks on his own. But he soon decided that real estate could be another way to make quick profits. Paul owns two condominiums around Fort Lauderdale and one in Miami Beach that he bought during the last year, in addition to the one where he lives. He plans to sell one of the Fort Lauderdale condos in June for what he believes will be double his investment.

“It really is a very hot real estate market and I don't know how long it's going to continue,” he said. “But in the short term, why not profit from it?”

Paul's path is an increasingly common one. The National Association of Realtors estimates that nearly one-quarter of home purchases last year were made by people who thought of the house as an investment rather than a place to live. Seminars promising to teach amateurs the tricks of real estate speculation have proliferated.

Real estate hot

Even at Harvard Business School, where students have traditionally gravitated to careers in investment banking and corporate marketing, real estate is suddenly hot. About 25 graduates have taken real estate jobs in each of the last two years, up from only six in 2001.

It is not quite the gold rush of 2000, when almost 200 Harvard MBA graduates flocked to technology companies. But even if they are not working in real estate, some of those graduates are now investing in it.

Andrew Farquharson, a member of the class of 1999, said he recently teamed up with a high school friend to buy a home in the Central Valley of California “out of pure speculation.” He knows three other classmates who have made similar investments.

“I look at this as a short-term investment,” said Farquharson, 36, who works for a venture capital firm, “and plan to unload it as soon as things look dangerous.”

The parallels between real estate and stocks extend into mainstream culture.

Real estate bulletin boards and blogs like and Real Estate Pimp have taken the place of financial chat rooms like Tokyo Joe's. ABC has a breakout hit in “Extreme Makeover: Home Edition,” and Home and Garden Television, a once-obscure cable channel, draws an average of 827,000 viewers in prime time.

The seemingly inevitable how-to guide inspired by Donald Trump — “Trump Strategies for Real Estate” by George Ross, one of Trump's assistants on his hit show “The Apprentice” — is a strong seller, hitting No. 177 on's list this month.

At the Nexus party in Brooklyn, Steve Nguyen, Romano's fiance, said he was heeding Trump's advice. “He says buy, buy, buy,” Nguyen said.

The same message is being trumpeted by David A. Lereah, chief economist of the Realtors association, who argues in his new book, “Are You Missing the Real Estate Boom?” that real estate investors will “experience substantial and satisfying wealth gains” into the next decade.

The question that looms over these books is whether they will suffer the fate of another optimistic talisman, “Dow 36,000,” a best-seller in late 1999. Its authors, James K. Glassman and Kevin A. Hassett, argued that stock prices, despite five years of roaring gains, “could double, triple or even quadruple tomorrow and still not be too high.”

The Dow Jones industrial average hovered around 11,000 when “Dow 36,000” was published. It dropped below 8,000 in 2002 and closed at 10,442.87 on Thursday.

Another lingering echo of the stock market boom is the role of the Federal Reserve. In the 1990s, the Fed kept interest rates relatively low because it saw little risk of rising inflation despite a booming economy, helping feed a fever for stocks.

Alan Greenspan, the Fed chairman, famously asked aloud in 1996 whether “irrational exuberance” was driving the stock market, but then backed off from second-guessing investors.

After the market plunged and the economy weakened, the Fed pushed interest rates down to near 50-year lows, helping to fuel the housing boom. This month, Greenspan made some comments about housing that offered a pale echo of his 1996 musings.

“Analysts have conjectured that the extended period of low interest rates is spawning a bubble in housing prices in the United States that will, at some point, implode,” Greenspan said in a speech in New York, adding that real estate speculation had shown a “marked increase.” Nevertheless, he said he did not expect a “destabilizing” drop in prices, in part because home prices across the country have never fallen significantly.

But by one measure, houses in at least a few metropolitan areas are as expensive as telecommunications stocks were in 1999, relative to their underlying value.

The average house in San Jose costs 35 times what it would cost to rent for a year, according to, a research company. In New York and West Palm Beach, this ratio — a rough equivalent of the price-earnings ratio for stocks — is almost 25.

In March 2000, the price-earnings ratio of the Standard & Poor's 500 — the combined price of the stocks, divided by their profits per share — peaked around 32, as it did for telecommunications stocks. The S&P's PE ratio has since fallen to around 20; it is down even more for the telecommunications industry.

Still, no matter how expensive real estate might be, it continues to provide many owners a return worth boasting about.

At dinner parties in Manhattan, Holly Peterson, who is writing a novel about the idiosyncrasies of New York's rich, said she frequently hears complaints about high home prices, followed by claims of quick profits. “They always hit you with their last jab: “Of course my money's doubled three times over since I got married,”' she said.

Five years ago, she said, friends at parties were crowing about “making millions of dollars on paper with $25,000 and $50,000 investments.” But “most of those people,” she added, “got wiped out.”

Wednesday, April 20, 2005

Will the walls come falling down?

From The Economist Global Agenda

House prices have been growing at a breakneck pace in many developed countries. This has encouraged householders to keep spending even during the global slowdown. But now that housing markets are looking soft, consumers may be forced to retrench

AMERICAN homeowners, particularly those who have just bought their properties, are full of reasons why the run-up in house prices in recent years will continue indefinitely. These days, however, this is beginning to sound like so much whistling in the dark. While prices rose by 11.2% in 2004, the rate of increase slowed markedly in the fourth quarter, to only 1.7%. On Tuesday April 19th, the Commerce Department announced that housing starts fell by 17.6% in March, the sharpest monthly decline since 1991. The next day, the Mortgage Bankers of America (MBA), an industry group, reported that mortgage applications had fallen the previous week, despite a slight dip in interest rates. Investors who thought that real estate was a haven from the volatility of the equity markets might be getting a little nervous.

But worse may come. House prices have received an enormous boost in recent years from falling interest rates, which enabled homeowners to sell their properties for a higher price without a commensurate increase in the buyer’s monthly mortgage payment. But as interest rates have started to rise, buyers have turned to increasingly risky forms of financing in order to keep their monthly payment from bankrupting them. The MBA reports that over a third of new applications in recent weeks have been for adjustable-rate mortgages, up from just 12% in 2001. Anecdotal evidence suggests that “interest only” mortgages, which allow borrowers to make no payments on principal for a period of years, are also on the rise.

These changes have allowed more marginal homebuyers to clamber on to the housing ladder. But if interest rates rise as economists expect, many of those buyers will find it difficult to keep up their payments. And with many putting so little down—a fifth of American mortgages in 2003 were for more than 90% of the purchase price—any fall in house prices could leave a lot of them with negative equity, forcing them to default.

The increasing riskiness of mortgages is not the only sign that America is experiencing a housing bubble. The ratio of house prices to rents is well above its historical average, as is the ratio of prices to median incomes. And people seem increasingly to be basing their house-buying decisions on the notion that the large capital returns of the past few years—house prices in America are up by 65% since 1997—will continue indefinitely. As with a stockmarket bubble, if this confidence is shaken, prices could begin to fall rapidly.

America is not the only country that has been experiencing a big run-up in prices. Its market isn’t even the most frothy. Between 1997 and 2004, house prices more than doubled in Australia, Britain and Spain, and nearly tripled in South Africa and Ireland (see table). And while America’s ratio of house prices to rents is 32% higher than its average value from 1975 to 2000, by that metric houses are even more overvalued elsewhere: by at least 60% in Britain, Australia and Spain, and by 46% in France.

Inflated house prices may have been a key factor in helping these countries weather the global slowdown in 2001. When household wealth is increasing, particularly housing wealth, consumers respond by saving less and spending more; economists call this the “wealth effect”. Explosive house-price growth thus encouraged consumers to keep their spending steady despite external shocks. It is probably not a coincidence that Germany, one of the few European countries where house prices have not been rising, fared far worse during the slowdown than its neighbours or America.

Unfortunately, when housing markets decline, the same process works in reverse: consumers have to cut back their spending and save more to compensate for lost home equity. Lower consumer demand generally means a slowdown in GDP. The sharper the correction, the greater the effect on the overall economy.

But how far will the market really fall? Prices have already begun to soften in places like London and New York, particularly at the high end, but it is possible that in most places price increases could simply moderate, giving incomes and rents time to catch up. An IMF study on asset bubbles estimates that 40% of housing booms are followed by housing busts, which last for an average of four years and see an average decline of roughly 30% in home values. But given how many homebuyers in booming markets seem to be basing their purchasing decisions on expectations of outsized returns—a recent survey of buyers in Los Angeles indicated that they expected their homes to increase in value by a whopping 22% a year over the next decade—nasty downturns in at least some markets seem likely.

A fall in American house prices could be bad news not just for American homeowners, but for the rest of the world. Robust American demand has supported export-driven growth in many economies, particularly emerging markets and Asia. If American consumers have to raise their abysmal savings rate, exporting nations will feel the pinch. And given the parlous state of the Japanese and European economies, it seems unlikely that they will be able to pick up the slack—particularly if many European countries are coping with the fallout from their own housing bubbles.

Most worryingly, a collapse in American export demand could trigger a vicious cycle. In order to keep their currencies low against the dollar, and thus boost exports to America, Asian central banks have been accumulating dollar reserves, which they have poured into Treasury bonds. This has increased the supply of capital in America, and thus been at least partly responsible for the borrowing binge that fuelled the housing boom. If house prices fall, and suddenly poorer Americans have to cut back on their purchases, this will shrink the supply of cheap credit from Asian central banks, pushing up interest rates and causing house prices to fall even further. Those who thought that housing was a haven may be in for a nasty surprise.

Tuesday, April 19, 2005

Steering clear of a recession

Bruce Bartlett

Last week’s meltdown in the stock market, with major indexes falling three percent, is only the latest indication that the economy is in fragile condition. One is even starting to hear the first whispers of the “R” word (recession). Although I think such expectations are premature, the financial sector of the economy is under growing strain that could burst and spill over into the real economy suddenly and without warning.

The basic problem is a simple one: the Federal Reserve is tightening monetary policy. Historically, this has preceded every major economic slowdown or significant market correction. For example, the Fed began tightening in mid-1999, the stock market peaked in early 2000, and clear signs of a recession were evident by the fall of 2000.

The Fed’s current cycle of tightening began in June 2004, so it is not surprising that we are starting to see the first signs of an impact. Since then, the Fed has almost tripled the federal funds interest rate from one percent to 2.75 percent. Moreover, there is every reason to believe that the Fed will continue tightening for the foreseeable future.

The reason is that the Fed is concerned about the reemergence of inflation. All the early warning signs of this are in evidence: the dollar has been weak on foreign exchange markets, commodities like oil are rising rapidly, housing prices continue to go up at an amazing rate, and the growth of productivity has fallen significantly. Although these factors have yet to seriously impact on consumers, except for the skyrocketing price of gasoline, it is only a matter of time before these fundamental inflationary forces work their way through the system and start raising the Consumer Price Index.

The Fed wants to nip this in the bud before inflationary psychology sets in. Once that happens, inflation tends to feed on itself as workers ask for extra pay to compensate them for expected inflation and lenders start tacking an inflation premium on interest rates. Once that happens, it becomes almost impossible to bring inflation down again without a recession.

The Fed must move gingerly, however, because monetary tightening creates strains in financial markets that can be very dangerous. One reason for this is that many financial institutions have been making easy money borrowing short and lending long. As long as the yield curve slopes upward, this works. But as the Fed pushes up short rates, the yield curve begins to flatten, which can put financial institutions into a bind if they have not been careful enough about hedging themselves.

The place where the greatest danger lies is with Fannie Mae and Freddie Mac, the two giant government mortgage lenders. Their portfolios are now so large—in the trillions of dollars—that even the tiniest mistake by them could roil markets. Evidence that some of Fannie Mae’s managers may have been manipulating its finances for personal gain is reason enough to worry about what else may be going on there. That is one reason why Congress and the Bush Administration have been stepping up their oversight of Fannie and Freddie.

Another source of concern in financial markets is the impending retirement of Alan Greenspan as chairman of the Fed. Having served in this position for almost 20 years, an entire generation of bankers and bond traders have never know anyone else in this critical position during their professional lives. It is not known who his replacement will be, but even if the choice is excellent there is bound to be some financial unrest during the transition.

Lastly, there are the dreaded “twin deficits” looming over financial markets. Huge budget and current account deficits mean that vast amounts of capital flows are necessary to keep them funded. So far, this has gone well, but that is largely because the Chinese have been so accommodating about financing them—effectively financing their own exports by buying large quantities of U.S. Treasury securities with their export earnings.

But now the U.S. is strongly pressuring China to stop doing this in order to allow its currency to rise against the dollar. It is hoped that this will reduce China’s production advantage in dollar terms and bring down the bilateral trade deficit. However, the cost to the U.S. economy if this happens could be greater than the potential gain. At least in the short run, any scale-back in China’s buying of Treasury securities might cause interest rates to spike very quickly. This could prick the housing bubble and bring down home prices, eroding personal wealth and putting a squeeze on those with floating rate mortgages.

Hopefully, this can all be managed smoothly and without either a recession or a market break. But it will take great skill and a lot of luck to avoid both.

Home buyer worry in two areas

By Scott Van Voorhis

If you're wondering what it will be like if the real estate bubble bursts, ask some homeowners in Dorchester and Roxbury.
The gas is running out of the recent real estate run-up in both neighborhoods, according to local housing researcher John Anderson.
Dorchester and Roxbury homeowners defaulting on mortgages rose 35 percent over the past year, said Anderson, of The Real Estate Analyst. And Dorchester single-family and condo prices are falling after record highs last year.
The jury is still out whether the bad news is just local - or a warning of a larger Boston area decline.
But a cooling off could hit Dorchester and Roxbury particularly hard, thanks to a growing number of high-interest, subprime loans.
``There is a whole confluence of factors,'' said Anderson, a longtime Dorchester homeowner. ``We've hit the wall.''
The numbers tell the story, with 65 homeowners facing foreclosure in Dorchester and Roxbury between April 2004 and April 2005, Anderson reports. That's up from 48 defaults the year before.
Dorchester single-family home prices dropped during the same period to $320,000 from $370,000, while condo prices slid to $245,000 from $265,000, Anderson said.
As the number of homeowners in trouble has risen, Anderson has seen an explosion in lending by high-interest-rate lenders.
It is a problem that James Campen, an economist from the University of Massachusetts at Boston, documented in a recent study that found a 60 percent rise in so-called subprime lending in Boston neighborhoods.
Other problem signs, according to Anderson, include rising interest rates and a proliferation of for-rent signs in two-or-three-family homes. Such small multifamilies have been a favorite of first-time buyers trying to break into the market.
``To use a cliche, it's the perfect storm. All the elements are coming together,'' Anderson said.
Still, Karl Case, a Wellesley College housing economist, was cautious about forecasting a price plunge based on Anderson's findings.
``I don't think what is likely to happen is a big bust in price,'' he said.

Thursday, April 14, 2005

Stock Market Suggests that Homebuilders on Extremely Thin Ice

The position of the homebuilding stocks is reminiscent of the jolly red bear in the kids’ game, “Don’t Break the Ice”. The homebuilder stocks sit complacent, atop a foundation of supporting sectors (or “ice cubes”) that are being knocked out from under on a daily basis. As each “cube” cracks, the position of these stocks becomes more and more tenuous. When the jolly homebuilder bear finally loses his support, his fall is likely to be fast and far. Tonight, I will examine several of the falling sectors as well as some that are being displaced. How long can the jolly homebuilder bear hang on? Some key charts say not much longer.

I recently scanned Investor Business Daily’s (IBD) list of 197 Industry group rankings, identifying all sectors that supported the US housing market. This scan is presented in the chart below which indicates sector rank in stock performance over the last 6 months (from 1- best, to 297 - worst), versus the ranking 3-months ago.

Thin Ice – Housing-Related Stock Performance Lagging Badly

Housing-Related Sector (Data from IBD
8 April 2005)

Sector Rank (stock performance over the last 6-months)

Rank 3 Months Ago (stock performance over the last 6- months)

Gain (Loss) in Rank versus 3-months ago.

Mortgage and Related Services




Household – Appliances




Savings and Loan (similar performance in other banks too)




Building Paint and Allied




Building Wood Products




Household and Office Furniture




Building Cement, Concrete and Aggregate




Building Construction Products Misc.




Building –Residential




The chart above clearly illustrates that the housing-related sector stocks are either presently ranked in the last quartile, or falling significantly in rank, or both. While the homebuilders presently rank in the top 8% of sectors in 6-month performance, all supporting sectors are failing to confirm the bullish performance. In my view, it is telling that the sector consisting of mortgage and mortgage related services is presently ranked dead last of all 197 groups after having dropped 108 places over the last three months. While conditions in the homebuilder sector were so favorable for so long that these stocks were going up universally, it is ominous that on Friday a small and lagging homebuilder, Dominion Homes, made a fresh new 52-week price low. Note Dominion Home’s 2003 sharp rise from below 15 to just under 40 in less than one year concurrent with all other homebuilders. Yet a rising tide no longer lifts all boats and this, it seems to me, is signaling that the end of the homebuilder stock bull market is almost upon us.

The most ominous aspect of the housing-related stocks is the ugly action in the mortgage related stocks, ranking dead last of all 197 IBD-categorized groups. We have all heard and are familiar with the action in pseudo-government related entities, Fannie Mae and Freddy Mac, yet in many cases, the less popular and/or completely private mortgage companies are telling an even more bearish story that is illustrated in the charts below.

They are all exhibiting bearish chart patterns which suggest that something is just not right in the business of home finance. These stocks generally can be shorted provided that appropriate entry points and stops are used.

Time to Call an Audible

While I had intended to illustrate more sectors and charts tonight, unfortunately, my high speed internet connection has been on the fritz and I cannot bring up the excellent charting service, Instead, with several sectors of the stock market appearing to be ripe for short sales, it may be appropriate to review an important concept in technical analysis – the head and shoulders (HAS) reversal pattern. This is a pattern that has appeared throughout the recent bull market, but has rarely run to completion all the way to the final trend reversal from UP to DOWN. Since October 2002, the typical behavior has been HAS formation followed by what appeared to be a neckline break. But in practically all cases, this apparent neckline break turned out to be a whipsaw into a sharp and tradable bullish rally. In essence, these pattern failures were telling us something about the general conditions of the stock market – that the environment was still bullish or at least neutral, but not bearish. However, in recent weeks, the appearance of neckline breaks of support (and no bullish whipsaw) in certain sectors such as auto parts and mortgage companies may be signaling a bearish change in general conditions of the stock market. The 6-week-old annotated chart of Redwood Trust (RWT) below, provides a good example of this. Although a head and shoulders pattern formed and appeared to break to the downside in late February, anyone going short at the neckline breakout got punished due to still bullish general market conditions. Yet as of today, the RWT neckline has been broken and RWT is now in an established downtrend (not shown).

The apparent new character of general market conditions must be considered from a tactical perspective. The following four factors need to be addressed in selecting an entry point for shorting into an identified HAS reversal pattern:

  1. The technical pattern must suggest that there is significant gain to be made by taking a position.

  2. There must be evidence that the technical pattern has been completed and that probability suggests the trend has reversed.

  3. An appropriate price must be established that would indicate the “improbable” is occurring, and a small loss must be taken on your part.

  4. A good risk/reward ratio between the potential gain (#1), and “improbable” small loss (#3) must exist.

As this applies to the HAS reversal, the most logical price in which to enter a short position is after several days have passed after the apparent neckline break has occurred and a bullish whipsaw has not occurred. This is because failure of the HAS patterns have tended to occur right after the apparent neckline break with a sharp break to the upside, on relatively high volume. Although there have been a few “breakouts” to the downside that have “worked,” the preponderance of whipsaw rallies have outnumbered the downside “breakouts” by a wide margin. For this reason, a rally back to the neckline, on low volume represents a lower risk point in which to enter a short position on a HAS reversal. This strategy results in an ideal low risk stop out point if the “improbable” occurs – a decisive close above the neckline. In the case of Dominion Homes in the chart above, a low volume rally back to 19 would present a good risk/reward ratio to enter a short. (That is, if you can be assured that a larger homebuilder won’t buy them out for $30/share in overpriced stock! This is a chart example – not a recommendation).

A Final Note on “Don’t Break the Ice”

Since my two daughters are 9-1/2 years apart in age, I owned this game at two separate times. The ‘80's version of “Don’t Break the Ice” had a scared looking man sitting on a chair with a fearful expression and tight grip on the chair that was placed on the “ice.” By the late ‘90’s the scared man was replaced with a jolly looking smiling bear on ice skates. While a case for the ‘80's version of the game, depicting what could be construed to be too sadistic, I’m afraid today’s jolly ice skating bear is too complacent.

Today’s Market

It was an ugly day and an ugly couple of weeks in the stock market regardless of where you were invested from the long side. The Dow Industrials were down 1.2%, the S&P 500 down 1%, the Nasdaq down 1.4%, the transportation index down 3%(!), the S&P Mid Caps down 1.84%, the Russell 2000 down 1.76%, and the NYSE composite down 1%. Gold was down $5.80 ($423.50/oz), while silver was down $0.16 (%7.06/oz), and the XAU and HUI were down 3.3% and 4.2%, respectively. Oil caught a slight bid finishing up 0.65 at $52.78, right about at its 50-day moving average. The rally in bonds continued as it broke what appeared to be resistance as shown in the chart below.

Gold and the dollar are at critical crossroads – gold is right on its upward trendline, and the dollar is right on resistance.

The gold and silver stock traders didn’t wait for these trends to be broken before selling as indicated by the HUI and XAU swoon.

Summarizing the action in the financial markets since about 1 month ago, I come up with the following:

  • Bonds Up

  • Dollar Up

  • Japanese Stocks Down

  • US Stocks Down

  • Industrial Stocks Down

  • Financial Stocks Down

  • Transportation Stocks Down (!)

  • Commodities Down (Oil Down)

  • Gold Down

If these are in fact, actual trends and not statistical and speculative “noise,” then the evidence suggests deflation. Should we lambaste those astute analysts who are of the inflationary school of thought? Being a humble chart reader, I would only suggest that trying to call the inflation or deflation scenario is like predicting whether Apollo 13 was going to crash to earth or careen out into space. Yes, the ship landed safely via extraordinarily skilled professionals in their prime and working at their best under pressure. So, similar to that situation, our economic “ship” may be able to land safely. To believe this requires that you also believe those officials making the critical economic decisions are extraordinarily skilled professionals, in their prime, and working at their best under pressure.

Since we started this article talking about head and shoulders reversals and homebuilders, it is apropos that we finish on this topic. Below is a 3-month hourly chart of the Dow Jones US Home Construction Index.

Note that the neckline has been decisively broken today with a downward move of over 4% on very heavy volume (not shown). If it doesn’t whipsaw back above the neckline soon (fast and tradable), the initial price objective would be about 725 to the downside. Today’s action in the homebuilders occurred in spite of a rallying bond market. It looks like the housing bubble is bursting right before our eyes. What would cause a rally back to the neckline? Fed speak about DE-flation and indications that the raisings of the Fed funds rate can be slowed, measured more, stopped completely, you get the idea.

Stick around; this could get interesting!