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Having
lived and worked in San Francisco
during the Tech and Dotcom bubble, I had a first hand glimpse into the bubble
mentality and the irrational exuberance of your average consumer. From Dotcom
companies throwing lavish parties (while reporting negative earnings) to
college students investing their school money in the stock market, to the
creation of "short- lived paper millionaires," I easily recognized
that this move up in the stock market was not sustainable. In the midst of
this bubble, many people would look at their stock options or 401k plans,
classify themselves as millionaires, and spend money in the economy that
further propelled the rise up in the stock market and further expanded the
bubble. The end result was that most of these stock options expired
worthless, investors lost millions of dollars in the stock market, and the
"paper millionaires" where no longer millionaires.
Throughout
history, you will find notable examples of manias, Ponzi
schemes, and bubbles that have ended up in disasters with investors cutting
back on their spending and scrambling to atone for their financial mistakes. This
scenario did not happen after the Dotcom bubble. Instead, investors shrugged
off their losses as they saw the value of their homes skyrocket. Consequently,
the rise up in real estate prices allowed them to continue spending and
temporarily delayed the US
economy from heading into a major recession. I believe that 2006 will be the
beginning of the burst of the real estate bubble, and that this burst will
have immediate and severe consequences on the US economy as a whole.
Your Mortgage Broker Does Not Know Best
As
real estate prices have skyrocketed in the last several years, there have
been some people that have argued that the move up in real estate prices is
sustainable. Mortgage Brokers, Real Estate Agents, Appraisers, and people who
lack an understanding of the markets have argued that rising real estate
prices are purely based on supply and demand. They point to the fact that the
supply of housing is decreasing, while the demand for these homes are
constantly increasing. This argument, however, is flawed. In the last several
years, homebuilders have been building homes at a record pace. In fact, there
are now more housing starts per person than there was 5 years ago. Although
there definitely has been an increase in demand for these homes, it has
mainly occurred due to the artificially low interest rates and exotic
mortgages that have allowed people to purchase homes that were traditionally
out of their means.
"Don't
you see the bidding wars?" "If you don't by now, you will never be
able to afford it!" The sad reality is that most people who have
purchased homes in the last several years could not afford to buy a home via
traditional means. By this, I mean, that if you took away the creative
mortgage packages (zero percent down, interest only, etc.), and forced these
homeowners in a fixed mortgage, they would not be able to afford their monthly
payment. Incidentally, when interest rates are at record lows, you want to
get a fixed rate mortgage. When interest rates are at their highs, and
heading lower, adjustable rate mortgages might make more sense.
This
idea that people have been purchasing homes outside of their means is
validated by looking at the average median home price versus per capita
income. As you can see in the chart below, the valuation of median home price
to per capita income is way out of historical proportions.
(Source:
www.piggington.com)
Although,
this chart specifically depicts San
Diego, you can likely apply these results to your
local market. Suffice to say, that the average income has not skyrocketed to
the degree that we have seen the real estate market skyrocket. Again, this
shows that the average person is living in a home that they can only afford because
of the low interest rates and because of the type of loan that they have.
Isaac Newton Knows Best
Newtonrd Law of Physics
states that "for every action there is an equal and opposite
reaction". In a similar manner, I believe that with every bubble, there
has to be an equal opposite burst. Our economy is heading towards a
recession; and the burst of the real estate bubble will be what finally sends
it there. Quite honestly, I did not believe that the real estate bubble would
last as long as it has. Nonetheless, I know that the longer a bubble lasts,
the more dramatic and severe the burst will be.
Real Estate Prices Decline in 2006
In
2006, we are already seeing signs of a slowdown in the housing market. In
recent weeks, home loan applications have fallen to a 3 ½ year low. I
believe that most everyone who could take advantage of the low interest rates
and exotic mortgages have already done so. The continual rise in interest
rates will undoubtedly price new home buyers out of the market. Even with an
interest only loan or an adjustable rate mortgage, higher interest rates will
most clearly mean higher mortgage payments. Given the fact that your average
American consumer has negative savings and that the average income is not
rising sharply, I see a sharp decline in the demand for new home sales in
2006.
Coupled
with a decline in the demand for new home sales, will be an increase of
available homes on the market. This increase in supply will likely come from
the following sources:
1.
New Homes Still Being Built
Even
in the midst of declining home loan applications, there are still new homes
being built. Because of the multi year rise in real estate prices, home
builders have scrambled to build homes and profit from this irrational real
estate demand. As a result, there are still a number of developments in the
works and new homes that will soon come on the market.
2.
The Speculative Home Buyer
According
to the National Associations of Realtors, 36 % of the home sales in 2004 were
second home purchases. Although I haven't been able to find out the number
for 2005, I can assume that the percentage is even higher. As real estate
prices start declining, I believe you will see the speculative home buyers
sell their houses and take profits (or cut their losses). Because most of
these second home buyers view these homes as an investment, they are more
quickly to act in the midst of declining real estate prices.
3.
The Over-extended Buyer
As
it stands, the average American has negative savings. In addition, because
they have adjustable rate mortgages, they will be forced to pay more on their
mortgage as interest rates continue to head higher. Most of these home buyers
do not have the necessary savings income growth potential to keep up with rise
of their mortgage. As a result, the likely scenario is that these homeowners
will be forced to default on their mortgages and walk away from their homes.
In
the midst of growing inflationary concerns, I believe that the Fed will
continue to raise interest rates in 2006. The degree to which they raise
interest rates will determine how fast this real estate market will begin to
unravel.
The Real Estate Burst Effect on the Economy
Without
question, the real estate bubble has fueled this US
economy in the last several years. I am amazed at the amount of times I have
heard about a friend or neighbor who decided to
refinance their home, get an adjustable rate mortgage, and take cash out for
some type of trivial expenditure. Why not? They would argue. I just made a
200k profit this year. This same irrational exuberance reminds me of the
"paper millionaires" in the Dotcom era who pointed to their stock
portfolio as a means to justify their spending. Although this spending served
to fuel the economy, it also served to further fuel this bubble and send your
typical consumer further and further into debt. In the future, those that can
afford to pay the additional amount on their higher mortgage will have to
"tighten their belt" and not spend as much money in the economy. Consequently,
they will hold on to their car a couple of years longer, not frequent their
local restaurant as often, and cut back on their overall spending. In turn,
this will flow into the economy and we will most likely see a much needed
recession as individuals refocus on savings and the re-accumulation of
wealth.
The Implications of an Upcoming Recession
Generally
speaking, a recession is a prolonged period of time where the economy is
contracting. During a recession, you will most likely see consumers spending
less money and saving more, a subsequent decline in the stock market, a rise
in unemployment, and a decline in real estate prices. The idea is that the
economy has to have periods of contraction after years of expansions. From
1991 to today our economy has been constantly growing. Some Economists might
argue that we did go through a recession in 2001. I disagree. Although we did
have some characteristics that were indicative of a recession, we also had
some glaring omissions. How can we have a recession that only lasts one
quarter, especially after we just came off a major stock market bubble? Why
would real estate prices continue to rise in a time of less spending and more
saving? In either case, the recession that is to come will be a multi year
recession that will serve to slow down this economy that has been wildly
expanding over the last decade and a half.
I
see the commodity markets as the premier place to invest during this upcoming
recession. Like the recession of the 1970's, I also expect to see rising
inflation and soaring commodity prices. Whether you invest in the metals
markets, agriculture, or basic raw materials, I believe that positioning your
wealth towards commodities will best position you to ride out this housing
burst and subsequent recession. If you are interested in learning more about
how you can take advantage of this commodity bull market, I am offering a
free brochure titled "The case for commodities". Additionally, I
also provide a free weekly newsletter to my clients. You can sign up for both
at: www.wisdomfinancialinc.com/brokers/emanuel.html
If you are interested in learning more about the
commodity bull market, I urge to pre-order my forthcoming book, "Commodities for Every
Portfolio: How To Profit from the Long-Term Commodity Boom".
Emanuel Balarie
Senior Market Strategist
Wisdom Financial, Inc.
Direct toll free: 866-465-0017
International: 949-548-2021
Emanuel Balarie is the Senior Market Strategist at Wisdom Financial.
As an expert on foreign markets, foreign currencies, and the precious metals
industry, Mr. Balarie often speaks at public
engagements and his research is regularly published in investment
newsletters. You can find out more about Mr. Balarie
and his services at www.wisdomfinancilinc.com
The risk
of loss in trading commodity futures contracts can be substantial. You should
therefore carefully consider whether such trading is suitable for you in light
of your financial condition.
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