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Old 08-22-2008, 04:19 PM
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Default Understanding this Cycle
Last Update: 18-Aug-08 08:57 ET

The defining characteristic of this business and financial cycle has been a massive correction in the housing industry. That has had direct implications for that economic sector and financial stocks. The implications for the rest of the economy and other stocks, however, have been exaggerated.

The Housing Correction

The housing sector has undergone a massive correction over the past three years.

Housing starts are down over 50% from the peak in 2005.

Home prices are down 15% to 25% over that period, depending on the index used.

Home sales are down about 33% from the levels of three years ago.

Residential construction has been a negative in the GDP data 10 straight quarters.

The severity of the housing correction can hardly be overstated.

Financial Stocks

The problems in the housing sector have had a direct, negative impact on the value of financial stocks.

Specifically, the values of mortgage-backed securities held by many financial institutions have declined as defaults on mortgages have risen and as the value of the homes backing the loans have declined.

The write-downs on the value of these securities have caused huge losses at financial institutions and ripped massive holes in balance sheets. This has decreased the value of the stocks of affected companies.

And yet, the now three-year old correction in the housing sector and nearly year-old problems in financial company earnings have not produced the much feared associated problems in other sectors of the economy. With the housing sector now showing signs of stability, these problems may never materialize.

Exaggerated Fears

There were two major threats from the housing industry crisis.

First, there was an understandable concern that lower home prices would lead to a contraction in consumer spending.

Second, there was a concern that the earnings problems at financial firms would lead to a contraction in business credit.

Neither has occurred, and neither is likely to occur.

The Consumer Refuses to Yield first addressed the implications of the housing implosion in a Sept. 25, 2006 Big Picture article titled "Housing: Correction or Crisis?" In that, we noted Fed studies that suggested an annual 10% decline in home prices would reduce GDP each year by about 0.25% due to the wealth impact on consumer spending. That is hardly dramatic, and is about in-line with what has occurred.

It is hard to separate the negative impact on consumer spending of the wealth impact from lower home prices, but it is not hard to show that consumer spending has not declined even in the face of the massive housing correction.

Here are the quarterly changes in the annual rate of growth in inflation-adjusted consumer spending (real personal consumption expenditures) the past 10 quarters, covering the period of the housing crash.

Q1 06 Q2 06 Q3 06 Q4 06 Q1 07 Q2 07 Q3 07 Q4 07 Q1 08 Q2 08
Real PCE 4.3 2.8 2.2 3.7 3.9 2.0 2.0 1.0 0.9 1.5

There has not been a single quarter of a decline in consumer spending.

Spending growth has slowed the past year, as payrolls have stagnated, and as higher gas prices have sapped consumer spending power, but the nonstop talk that a recession will develop because of a pullback in consumer spending has simply been WRONG.

The Credit Crisis is NOT a Credit Crunch

Another feared implication of the housing crash has been that a credit crunch will result from the earnings and balance sheet problems at financial firms.

Here the problem is partly compounded by imprecise language.

There is a credit crisis on Wall Street. There is a lack of liquidity in the secondary market for mortgage-backed assets and many related securities.

That is not the same, however as a credit crunch.

A credit crunch is defined as a contraction in availability of credit as reflected in declining levels of loans. This has not happened.

The simple fact is that the level of outstanding commercial and industrial loans (C&I loans) was up steady last year and has risen every month this year.

Here are the data from the weekly H.8 report from the Federal Reserve. Data are in billions of $.

Jan Feb Mar Apr May Jun Jul
C&I 1452.6 1462.6 1484.0 1493.9 1500.5 1507.5 1515.0

There is no doubt that lending standards have tightened. The quarterly Fed report makes that clear. But, it is illogical to assume that just because a majority of banks respond to a questionnaire by stating that they have tightened standards, that a credit crunch has developed.

Banks are tightening standards from what had been extremely loose standards. And, they may be tightening standards for mortgage loans but not as much for C&I loans. Regardless of the surveys, the hard data show lending is continuing.

(It is sometimes noted that commercial paper, another form of credit for companies, has declined over the past year. That is true, but the decline has been in financial company commercial paper. This is not at all surprising. Nonfinancial commercial paper has not declined and remains a means of obtaining capital for companies outside the financial sector.)

The bottom line is that it is WRONG to say that there is a credit crunch. Nonfinancial companies have access to the credit they need to grow and manage their businesses.

Stock Market Implications

The stock market retreat that began in late 2007 was a direct result of the earnings problems at financial firms. That sinking tide lowered all boats, assisted by fears that the housing sector problems would lead to an overall recession.

The earnings problem, however, has remained largely isolated to the financial sector. Nonfinancial companies have maintained earnings growth. In the first quarter, nonfinancial companies posted 7.0% year-over-year earnings growth, followed by 4.6% growth in the second quarter.

Now, there are signs that the housing market is bottoming. This is not to say that a recovery is imminent. Housing starts and home sales are not likely to recoup any significant portion of their three-year decline any time soon. Nor are home prices likely to start higher any time soon.

Nevertheless, housing starts in June were up 6.6% from December 2007. Existing home sales for July are expected to increase to about the level of December 2007. The charts of both show a clear bottoming trend in recent months.

As the housing market stabilizes, it could lead to recognition that the broader economy has not been impacted nearly as much as feared, and that many stocks were punished far more than deserved based on their earnings trends.

That in turn could lead many of these stocks higher over the next few months, and set up a reasonably good year-end rally for nonfinancial stocks. The reward/risk in nonfinancial stocks has improved (financial stocks remain a separate, higher risk, higher reward scenario).

What it All Means

The housing crash has created an understandably negative tone which has adversely affected consumer and investment sentiment.

On top of this, the spike in energy prices and the (mathematically modest) declines in payrolls have created an environment conducive to shrill journalistic claims of recession or worse.

Yet, the fact remains that housing is the only major sector of the economy that has contracted. Consumer spending, business investment, exports, and government spending have each increased EVERY SINGLE QUARTER in the GDP data over the past year.

The overall economic situation is of a major contraction in the housing sector that has not had significant ripple effects for other sectors of the economy, and shows no sign of doing so in the future.

This disconnect from the reality of the limited implications of the housing crash and the fears associated with it creates investment opportunities. Longer-term, nonfinancial companies now present many good reward/risk scenarios. Stocks such as 3M, GE, IBM, and others reflect good values with good dividend yields.

This is not to say that the market is a screaming "buy," but it is still our opinion that it would be wrong to panic on the fears that have been so prevalent through 2008, and that good, nonfinancial companies will deliver long-term value.

The housing crash is the defining characteristic of this business and financial cycle, and understanding that can help you make wiser investment decisions.

--Dick Green,
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