For the past four years, the US economic engine has mostly been powered by housing sales and the throttle has been wide open. The fuel for that engine has been low interest rates. The engine has been running so hot that today’s equivalent of day trading is flipping condominiums for fun and profit. Some people have flipped properties in as little as 24 hours – a sign that the engine is overheated. One study by the National Association of Realtors estimated that 23 percent of homes in 2004 were purchased primarily for investment. As the fuel gets more expensive, how will a slowdown in the housing market affect the economy in general?
If you’re reading this in 2006, you already know the answer. But here in Spring 2005, I want to try to address the question by painting several scenarios for what the impact could be. I’ll start by explaining three important concepts – liquidity, the yield curve, and the trade deficit – and then try to highlight the scenarios that I think are worth considering.
If the price of residential real estate drops, where will the money go? There are only so many places it can go. Commercial real-estate has boomed, filling downtown office buildings up with long-term leases, so their value is likely to continue. People aren’t going to sell their homes until they have to, but they may have to unload their investment real-estate as prices cool off.
Today many of the more liquid markets are already full of cash. The bond markets are full of foreign money. Commodity prices are already high. Oil is at a peak and energy stocks are already over the top. Banks and high-risk lenders are all printing money with credit cards and low-interest loans. Many stock prices are precariously perched, while others are stubbornly stuck in the mud. Warren Buffet says he’s had a hard time finding any good investments and is sitting on the sidelines with $43 billion in cash.
Those who follow liquidity say there aren’t that many places for the money to go. One place would be in precious metals, which always seem to form their own bubbles when the clouds of uncertainty gather (see below).
Liquidity is an important factor, because the more "stuck" you are with a bad investment the longer it could take you to get rid of it, and the more prices could crash. If money pulls out of several markets at once, that could make everyone nervous. If money sloshes from one overheated market to the other, that will increase volatility and potentially magnify other effects.
The Yield Curve
Economists often look to the yield curve (which shows different rates of return for bonds of different maturities, from short-term to long-term) as the best crystal ball for the economy. Normally, the curve is positively shaped, like the top of a Porsche, showing that short-term rates are naturally lower than long-term rates. In times of extreme optimism, the disparity is greater, and in times of pessimism the curve flattens out – bringing short-term rates of return closer to long-term rates.
Today, the yield curve is heading toward and will likely go flat. As Alan Greenspan raises short-term interest rates, there won’t be enough pressure on long-term rates to drive them up, so the difference (also called the “spread”) will diminish. Speculators who have routinely made money on this spread will find that their free lunch has disappeared.
When long-term rates are even lower than short-term rates, the curve is said to be inverted. Everyone knows that an inverted yield curve leads to recession, typically a year later.
Here’s a really cool yield-curve animation that shows every month of the US Treasury yield curve for the past 30 years (don’t click the play button, just grab the diamond and move it by hand, and make sure to pause at November 2000):
The Asians Have All Our Money
It may be true that the Asian economies are growing much faster than our aging Baby-Boomer and no-growth economies in the US and Europe, but hey, look at all the cool toys we have! Does it really matter if they have all our money? To understand our trade deficit, look where the profits are.
When you buy a shirt made in Malasia, you’re not paying that much money. The owner of the US brand whose logo is on the shirt is more profitable than the company in Malasia that made the shirt. So most of the profits stay in the US even if most of the money goes to pay Malasian workers.
The situation is even more extreme when you buy a new laptop for $2,000. Of that $2,000, about $100 in profit goes to the distributor, $300 in profit goes to the retailer, about $250 in profit goes to Microsoft, about $60 in profit goes to Intel for licenses on software and chips, about $40 in profit goes to the (probably Chinese or Japanese) makers of disk drives, screens, power supplies, etc. And about $20 in profit goes to the Taiwanese company that put the whole thing together and stuffed it into a box and put it on a boat. By far the lion’s share of the profit goes to US-owned companies, and that profit is what drives the stock market. On the other hand, much of the money (if not the profit) goes to pay the Chinese or Japanese workers their salaries, and that money gets taxed by their government and comes back to the US as investments in treasury bills.
So yes, the Asians do have all our money, but they don’t have anywhere else to invest it but in US T-bills (and possibly stocks). Japan is the largest holder of US T-bills, but China’s share is increasing. Some people fear the leverage this will give China, but in fact the money really has nowhere else to go. Unless another government starts paying spectacularly better interest on debt that is as safe as US Government debt, or if Asian companies become more profitable, the money is likely to stay in the US.
And now you know why the long end of the bond market is not going to go up any time soon: the Asians have nowhere else to put their money.
In the long run, this could change, and the change could be disruptive. Japan is now China’s largest trading partner, and vice versa. If China’s middle class starts looking for ways to make higher salaries, China may have to weaken the bond between the Yuan and the dollar. Other Asian currencies may also devalue the dollar. Then the US – the world’s largest debtor nation – could find itself in a downward spiral where our dollars no longer buy the stuff they make and our credit ratings start to slip. This is a long-term scenario that is probably based on politics (like China’s demand for Taiwanese fealty) and other factors (like war) as much as on economics. Tough to tell now, but being in debt up to your ATM card doesn’t make the situation more comfortable for the US.
Now, with those three concepts in mind, let’s look at some potential scenarios for the next couple of years ...
The Bambi Effect
Some people say interest rates will rise gradually and there will be no sudden dislocations. As prices of housing go up moderately, other industries and innovations will spur new economic growth. People still need a place to live, so housing prices may come down a bit in some markets but in general the strong demand for homes will continue. They contend that when the Fed Funds rate goes from 2.5% to 4.5% monetary policy will be in a “neutral mode,” striking the right balance between carrot and stick for the economy to continue growing modestly. I call this the Bambi Hypothesis, because it envisions a gentle transition out of the real-estate-driven economy into a new round of efficiency and production that keeps the economy frolicking along in the meadow like Bambi, undisturbed by outside influences.
The Bambi proponents say that if you look at the yield curve more closely, it’s more accurate to say that as the yield curve bends toward inversion, the chances of recession go up. Some people say that the curve is going to have to look like a canoe before we can count on a recession in 2007:
The main driver of the Bambi effect is that everyone expects interest rates to go up gradually and level off. Technology should continue to increase worker productivity. GDP looks like it’s going to keep growing for the indefinite future. Even though many manufacturing jobs have been exported to Bangalore, Americans seem, for the most part, to be working. The low dollar helps us export what we make to Europe. According to the Bambi-ites, it’s okay to buy an index fund and hold onto it, because the markets should continue their relentless upward climb.
If the dreaded inflation monster rears its ugly head, Greenspan could keep interest rates on the low side, so the Bambi scenario is a real one.
The Glass-Half-Full Effect
Some people look at the situation in their usual balanced way, saying that yes, the end of the real-estate economy is near, but other economies are on their way. We’ll see a bust in the housing and asset-based markets, but technology and medicine and exports will lead the way out. They can see plenty of volatility, but overall the economy will continue chugging along. Yes, there will be losers, but there will also be winners. Once people stop buying condominiums in Florida, they’ll go back to mutual funds, which will look to small-cap stocks, biotech, health care, transportation, energy, and another tech rally. And don’t forget, American consumers will continue charging on their credit cards until the undertakers pry them from their cold dead hands, so at least some banks and most imports will continue to thrive.
Part of this effect is that momentum strategies have suffered in the past few years, as the stock markets have mixed sideways movement with sudden upward lurches (as we saw last year and the year before). The trend-followers have had a more difficult time spotting trends and jumping on board. The contrarians are doing better, but it’s been rocky. For a few years now, the hedge fund honchos have been saying that the easy money has already been made.
According to the glass-half-fullers, there’s a tremendous opportunity to make money in the next few years. All you have to do is short anything asset-based and short manufacturing, then buy undervalued service, tech, and health-care stocks. But you’re going to have to choose carefully, they say, as most indexes are likely to go sideways for the next few years.
The Godzilla Effect
The serious contrarians, on the other hand, have kept their powder dry, waiting for just this moment. According to them, we are in the calm before the storm, strongly disputing Alan Greenspan's latest prognostications that the coming rise in interest rates won't be “disruptive.” (What is Greenspan going to say -- that it's going to be disruptive?)
Many people watching the financial sector believe the Godzilla model is appropriate. They believe the rise in interest rates will effectively stomp the housing and consumer-credit markets like Godzilla through a cheap movie set. Just as Godzilla completely destroyed some buildings, did some amount of damage to most, and left certain buildings completely untouched, the coming debt crisis will probably be selective in who it punishes most. It’ll hit hardest where there is the most leverage and where the most money has been made in the past few years. It’ll affect consumer credit across the board and cause a ripple effect as consumer confidence and other indicators get sucked into the same hole.
The Godzilla proponents do not think the coming credit shock is already priced into today’s markets. They have no doubt that many financial stocks and asset-backed securities (like REITS) will be hit fairly hard. They are worried about corporate and government bonds that have extra leverage and derivatives around them, making them more vulnerable to small changes in the yield curve. The seismic rumblings are already on the tape (Enron is far in the past, but GM’s recent downgrade by credit watchers may be just the beginning of a new corporate credit implosion). Greenspan himself said last November: “Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now is obviously desirous of losing money.”
The Godzillists go further, saying that the credit markets will feel the coming crunch almost across the board. The higher the yield, the bigger the hit. Many of the debt-based portfolios that are currently in fashion will suffer.
I know what you're thinking: “Hah, the contrarians said that last year, and they were wrong! Look at all the good news coming out of our economy.“ But this year is different. This year the bubble signs are all firmly in place. Where will the money go? A lot of it will simply disappear, vanished with the drop in housing prices. Much of the rest of it will go to cash or high-value commodities. There may be other bright spots, but why go for nickels and dimes when you can pick up quarters shorting banks that aren't prepared for a flat yield curve?
If there’s a bright spot, it’s that you can now identify which tranches of loans are most likely to go bad first, and sharp traders will be discounting those tranches sooner rather than later. Thanks to hedge funds, credit markets are now much quicker to react to changes and therefore more efficient. But on the other side, say the bears, Greenspan has been inflating the bubble past its breaking point for two years too long, allowing too much cheap credit to build up, and the real-estate economy is going to pop within 12 months. Quite simply, says one, “the coming credit implosion is going to hit wherever it can cause the most pain for the most people – it’s going to be the flip side of the free ride they’ve been getting for the past five years.”
Fanny Mae and Freddie Mac – two companies that have participated in the wholesale overleveraging of the US economy, have already shown themselves as the next Enrons, and we’re just beginning to learn how deep that rabbit hole goes. According to Jim Willie CB, professional market curmudgeon, "Fanny Mae deservedly receives a tremendous amount of criticism. It has become the mortgage industry poster boy for uncontrolled inflation, accounting fraud, executive pilfering, and collectivism for home ownership."
The Yield Curve Inversion Effect
Alan Greenspan says it's a “conundrum” that as he continues to raise short-term rates, the long term rates haven’t changed. This is one of those unusual signs that says we’re in different territory than we’ve been before. Greenspan can’t explain it. How about all the massive piles of Asian money looking for long-term treasuries, given that the money has no place better to go?
The Chinese Yuan probably should let go of the dollar and let it devalue a bit, but it’s not happening, so the pressure is just building up. This will create another crisis in the future, one that may hit just as the US economy teeters on recession. On the other side of the Pacific, the Japanese have been quietly saving and repairing their economy, to the point where they are now the most healthy economy in the world. Japan is a nation of savers, while the US is a nation of spenders. Does this remind you of any fairy tales you were told before going to bed as a child?
According to Jim Willie CB, "Since 2001, when the Fed began a dozen rate cuts, the expansion of household debt, the enormous federal deficits, the mind-numbing growth in money supply, the insanity of wasteful consumer spending, all of which continue to spiral upward, these point to an extremely bad foundation for the economy and Weimar symptoms of inflation.”
Think of it this way: the Chinese economy is only about 12% of the US economy, and when it gets to about 30% of the US economy it will turn into a much stronger animal, and their currency policy could become ours.
Something to think about: The Contrarian Thinker.
It would take several more dominoes to fall, but the yield curve could invert. In fact, some people have even speculated that the long end could drop down below the short end (this is called reversing the curve “the hard way”). No matter how you slice it, there is a chance of a recession, and the more factors that show up to kick our economy in the teeth, the more real that chance gets. A sub-scenario of this includes deflation, which no one expects but could throw some seriously cold water on the whole show.
Yes, a few people think this economy could simply crater and leave a smoking hole. I’m not one of them, but I have to admit the chances are nonzero. It pretty much happened in Japan a decade ago.
Seeing the Pin Coming
Now that I’ve taken you from “irrational exhuberance” down through the “conundrum” of the yield curve, I bet you’re wondering what I personally think will happen. If that’s true, you’ve been completely fooled by my act, playing an economist when in fact I took my last macro-economics class in 1979, and if I remember correctly I got a B-. But I will throw in my ten yen, and you are welcome to take it for what it’s worth. I will pseudo-prognosticate between now and the end of 2006 (and I refuse to pick Oscar winners, so don’t ask) …
The real question is: What’s the second derivative going to be? The second derivative measures how quickly the changes will occur. If things happen quickly, many dominoes will fall. But if they happen gradually, there may be time for damping effects to soften the blows.
When markets are inflating like balloons, it's hard to see the pin coming. I think we are, right now, at the peak of the housing bubble. I think it’s going to pop sometime between May and October of 2005, because people prefer to put off what’s coming until it finally arrives. When it does, everyone in the herd will go the same direction at the same time. I can’t tell you which rate-hike will be the pin that pops the bubble, but you don’t need much of a prick when the pressure is this high. Then the pop should be pretty audible, especially if you’re a real-estate agent.
If you are an owner trying to sell real estate, get it sold before summer. If you are thinking of buying real estate, keep your powder dry. I’m sure there are a few regional housing markets that won’t be much affected (Montana?), but in general I think the real-estate economy will officially end in May, 2005.
The problems at Fanny Mae and Freddy Mac herald the coming implosion of the bond market. Fanny Mae is the canary in the coal mine of the bond market. The bond market has many moving parts, some of which will simply melt, others will fly off, and much of the rest will get soft and mushy. Holding value in a bond portfolio will be a major accomplishment between now and the end of 2006.
I personally think most micro-cap and small-cap stocks will have a hard time growing over the next two years, because they aren't as liquid as big-cap stocks. We've seen a good run in small caps over the past few years, but I think investors will be too distracted with debt problems and won't want to be stuck with small-cap stocks.
I believe the price of gold will rise, but I can’t bring myself to buy it. Just so people know where I stand on the topic of gold, I’m going to digress for a second and give you the elevator pitch.
Gold is not rare. You no longer look for gold by looking for seams or deposits. Gold is everywhere in minute quantities, and we now know how to harvest it. There’s more gold in the top two feet of topsoil in Nevada than in all of Fort Knox. The technology needed to extract it is a fleet of earth movers and a big sheet of plastic. If the people in the gold industry had the financial incentive to double the current world’s supply of gold in the next ten years, they could do it (and the environment would be the victim, because gold mining is tremendously destructive and toxic). If gold didn’t have a history as a financial instrument, it would just be another industrial metal (mostly used by the electronics industry and a few jewelers). When the price goes up a bit, the gold extractors can get more where that came from, no problem.
That said, however, there probably is a terrific opportunity to make money in gold over the next 18 months. But as the bad news piles in, the smart money will already be in gold and then the greater fools will follow.
I can’t tell you much about Christmas 2005, but I can practically guarantee that Christmas 2006 is going to be no fun. By then, the cows will have come home to roost and the chickens will have hit the fan. By then, the average husband and wife will be looking at each other across the dining room table, knowing they won't be able to make their upcoming mortgage payments. Just in time for the new bankruptcy laws to make things even worse. I can’t imagine the stock market making it’s usual 11% per year over the next two years (of course, I couldn’t have imagined in the past two years, either).
I’ll Take Godzilla to Win.I am sure there will be some bright spots in the economy, but I also think that by the time George Bush is done with his second term, there won’t be any middle class left in America. I think by 2008, the US will meet most of the qualifications for a third-world economy. I won’t be surprised to see Warren Buffet holding onto even more cash at the end of 2006 than at the end of 2004. As a wise man once told me: “Money is hard to make and easy to lose.”
My advice: Preserve capital first, then look for clever ways to capitalize on the coming volatility. The US economy should silently slip into neutral sometime this summer and then coast along, losing speed, until something comes along to get it going again. It may be a while. It all depends on the second derivative.
If you’ve read this far, you should probably read: The Big Picture