Saturday, April 09, 2005

Sentiment Versus Sensible


Rich Karlgaard

The trick is always in the timing, isn't it? Home prices have soared into deep space. Airline stocks remain grounded. Time to short one and buy the other? You could make a killing. You could get killed, too. This hedge looks sensible on paper. But the market is not paper, and it acts sensibly only in the long term. In the short term markets swing on sentiment. And America is crazy about real estate right now.

Crazy enough to be a bubble, says John Makin, an economist with the American Enterprise Institute. Makin writes on the AEI Web site (aei.org): "The ‘cab driver test' flashed its second bubble warning light to me just recently when I arrived in Key West for the annual winter vacation with my family. Without prompting, our cab driver told us of a Key West real estate market on fire. Condos that were selling a year ago for $600,000 cannot be touched for $1 million today … [yet] room rates and rental rates in Key West have hardly budged. The implied return on investment in real estate is tied to an expectation of ever-rising prices, not to income from property."

Makin cites more evidence.

• Between 2000 and 2004 house prices in the U.S. rose more than 40%--the fastest rate of increase since World War II.

• The rate is accelerating. During 2004 house prices rose 12.5%. In some parts of the country they rose 30% to 40%.

• Meanwhile, the ratio of average yearly rents to house prices has been dropping, from 5% nationwide in the 1990s to 3.5% last year. Makin says that this is "reminiscent of the way earnings plunged relative to soaring equity prices before the tech bubble burst in March 2000."

• The housing boom has boosted American household net worth by $6 trillion since 2000.

How did we get here? Federal Reserve Chairman Alan Greenspan was badly frightened by deflation, says Makin. The maestro printed money to buoy up the U.S. economy after the 2000 tech stock collapse, the Sept. 11 attacks, the recession and the corporate scandals, as well as in response to the emergence of China "as a new mass supplier of inexpensive traded goods." The flood of money brought down borrowing rates, and home buyers went crazy. Clever mortgage brokers were happy to accommodate them.

Is Makin right about a bubble? He has a canny record of detecting speculative bubbles earlier than others do. Sometimes too early. Investors following Makin's logic can bail out of a high-return investment too soon. And housing, a bull would tell you, is not a liquid asset like stocks. People buy for a host of reasons, many of them emotional. They tend not to sell their houses in a panic. So who is right about house prices, Makin or the Americans who've bid them up?

Each has it about half right. Unless Greenspan begins hiking interest rates in half-point increments--his last seven hikes have been quarter points (a "measured pace" in Greenspanese)--average house prices won't collapse. They will simply stop rising. A few hot coastal markets could drop 20%, but overall the American house market will not crash.

Will $58 Oil Last?

Some airline stocks look like a buy. Last year U.S. domestic airlines lost, all together, $6 billion. This year they appear to be ditching into another sea of red ink. As an investor, you should be turning cartwheels of joy. How could anyone love airlines? Because their losses can be blamed on high fuel prices. This is old news, yet it remains baked into the prices of the stocks. The case for buying airlines is if you think fuel prices are headed down.

You should.

The spike in fuel prices--oil hit $58 a barrel as this issue went to press--is caused by three factors: world demand (from China, etc.), which is said to be outstripping supply; speculative hoarding because of terrorism and wars in the Middle East; and in the U.S. the punk dollar, which has driven up all commodity prices, oil included. But two of these factors are trending better: the Middle East and the dollar.

As for oil supplies, put your faith in Daniel Yergin's guess that world oil supply will grow for another 30 years, even as fuel-efficient hybrid engines come into play. Yergin is chairman of Cambridge Energy Research Associates (CERA) and an authority on energy policy and international politics and economics. He's watched the price of oil for 35 years and has seen everything that affects price--wars, peace, booms, busts, gluts, panics, solar euphoria and Kyoto clouds.

Through it all, Yergin has put his faith in the markets. He says oil producers always respond to high prices by finding new sources of supply. GPS satellites are just beginning to be used to locate new reserves. Stop sweating over oil, Yergin told a group of CEOs at a Forbes conference last fall. Oil will slide to $40 a barrel sometime in 2005.

If it does, a $10.80 share price for American Airlines (AMR) will look like a steal. Four years ago AMR was selling for $44. In January 2004, when oil prices were hovering around $34, AMR sold for $17. American suffers because as an older carrier it gets lumped in with United and Delta--the former in bankruptcy, the latter teetering on the edge--and not with discounters like Southwest and JetBlue, both of which the market likes.

Sentiment runs against American. The sensible see a buy.

1 Comments:

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