Investing is complicated and sometimes contradictory. It is at odds with the normal human temperament of intuitive optimism. In contrast, investing demands that we ignore our heart and listen to our brain. Emotion can lead us to bad decisions: Euphoria tries to keep us invested at market tops while despair makes us turn away when the markets are cheap and present opportunity. At the moment we confront despair as we face a recession in the coming year, so we need to expect the wave of pessimism that usually accompanies a market bottom.
I wrote about the impending crisis in the sub-prime mortgage market crisis three months ago in the Oct. 4 edition of Switch. However, it was clear back in January 2007 that the gains seen in real estate were unsustainable. Home values could not continue to rise 10% every year. So we prepared for the damage that would result from the unwinding of the mortgage bubble — selling stocks dependent on consumer spending, investing overseas and raising large cash positions.
After some failed attempts to slap bandages on the issue, the markets have finally begun to return to equilibrium. This is the inevitable result when supply overwhelms demand to the degree seen in residential real estate.
The statistics are startling. New home sales fell 34% in November 2007 vs. a year ago, while sales of existing homes dropped 20%. At the current pace of sales, it will take another nine months to clear out the inventory of new homes.
Home prices are falling at an unprecedented rate. The October 2007 S&P/Case-Shiller Index of home prices dropped a record 6.7% from the previous year. For sellers, the worse news is that the rate of decline is accelerating.
Declining home prices shuts off a vital source of funds — home equity borrowing. In 2006, roughly 7% of disposable consumer income was drawn from housing value. The U.S. consumer continued to borrow and spend past any reasonable point. The amount of debt is staggering. Credit card debt is at an all-time high, home equity is tapped out and there are increasing delinquencies in both. Meanwhile the Gross Federal Debt tops $9 trillion.
The housing market trouble has spread into non-housing areas. Lending standards have been tightened as a result of the crisis (known as closing the barn door after the cow is long gone) and credit has been squeezed. This squeeze has cut off the money that supported the takeover boom of the last few years — a boom that kept a floor under stock prices. Borrowing by private equity firms totaled more than $500 billion in 2007. Buyout funds accounted for $200 billion and real estate was next at $75 billion. The window for these loans began closing during 2007 as 59% of the funds were raised in the first half of the year alone.
Bill Gross, the managing director of PIMCO, a firm that manages $720 billion in fixed income, thinks that the recession started in December. A recession is defined as two consecutive quarters of declining growth. The stock market averages a 28% decline during recessions. For strategic investors with cash in reserve, a drop in prices is a chance to buy asset classes on the cheap.
Buy low and sell high. It is never easy. But it is very rewarding.
Terry Davies is a portfolio manager at Investment Management & Consulting Group, a registered investment advisor in Portland. Analysis of the financial markets is not meant as investment advice. Past performance is no guarantee of future results. Feedback is welcomed by phone: (800) 605-6552 or email: tdavies@imcgrp.com.