As Goes Housing?

October 1, 2006

Dear Investor:

Real estate is once again something you live in. Now that year-on-year median home prices are down nationwide, the flippers, speculators and touts are gone. Replacing them are the debtors, the foreclosed, and the remorseful. Two questions emerge: 1) How bad will this get? 2) Will the rest of the economy go with it?

The answer to the first is very. While people who bought primary residences with fixed rate mortgages will do okay in the long run—even if they did buy at the top, in August of 2005—those who gambled on second-rate investment properties or adjustable-rate mortgages will suffer dearly. Denial still defines the discourse, just as it did when Nasdaq started to crack in early 2000. Many said the damage would be temporary and short-lived. That punditry couldn’t have been more wrong or less helpful. The same situation is developing now, as promoters of the industry try heartily but ineffectually to save a sinking ship. While prices remain sticky due to sellers holding out for boom-time prices, relentlessly rising inventories tell the real story. The National Association of realtors reports that the number of unsold homes has reached 3.92 million, the most since the housing recession of 1993. This number is a recipe for real estate disaster and suggests that the bear market will be deep and long.

Will the national economy go the way of housing? The answer here is more complicated. Though housing has comprised a large share of GDP over the past few years, the damage caused by its decline is likely to be shallow and short. That’s because the economy is firing on two colossal cylinders—strong employment growth, and unprecedented global growth. More, a third is about to be added: corporate cash.

Corporate balance sheets are the most flush they’ve ever been. That money is starting to flow through the economy, either through buybacks, dividends, or spending. As cash is shed from corporations over the next 12 months, GDP growth should get at least a 100 basis point boost, replacing more than half of what housing takes away. Netting out the additions and subtractions would pull down GDP from its 2.6% present level to approximately 1.5%, well below J.P. Morgan’s 2.5% annualized estimate for the next three years. GDP at these levels would not spell recession, but it would mark a slowdown. Could the slowdown ripen into recession? Yes, but unless corporate spending fell off a cliff, it would be relatively mild.

The doomsday scenarios of depression and cataclysm being trumpeted are unlikely—and if they occur, would result from something far worse than this housing bear. In such a scenario, the Fed would lower rates, which would save the current economy, but would foment yet another bubble in some asset class as yet unknown.