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At Arm's Length: 04.12.05
The global reaction to this has started mutterings of protectionism. But from whom? Many of the companies whose investments are based in China also trade on American exchanges. Steep tariffs would simply offset themselves, pushing shareholders to question the wisdom of imposing archaic trading rules on a newly minted global marketplace.
Healthy economies are lean and vibrant, able to grow and produce profits during manageable interest rate environments, with ample and reasonably priced fuel, an accommodative tax base, and of course, pricing power. Alan Greenspan has had increasing difficulty aligning these important characteristics of late. He has been using the considerable influence he exerts over elected officials and decision makers in various industries to try to fix this problem.
His efforts to date, though have accomplished little. The idea of raising interest rates to help smooth the rough edges of the economy is necessary. His persistent stumping and his softly worded warnings have fallen on deaf ears however allowing one of the most dangerous financial situations ever to continue grow. This problem is solely Mr. Greenspan's creation.
As the first quarter closed, the S&P 500 index was down 2.15% with a gain of only 6.69% for the previous four quarters ended 3.31.05. No real strength there. By keeping short term rates so low for so long, the economic catalyst has rested solely with the consumer. That customer however will be challenged in the coming years.
The quickest and most popular measures of the health of an economy when the stock market is providing lackluster performance is to examine health of the housing market. And that is exactly what we all seem to be doing these days. Unfortunately we are looking at the value of our homes and not the underlying debt of this asset class.
Any significant shift in the housing market, specifically a downward revision in the worth of our homes will directly effect 75% of the Americans in this country. Changes in the interest rate environment usually ushers in an era of more reasonably priced homes. This is done by changing many of these current and over extended equity calculations as the cost of borrowing increases.
In April of 2004, NAHB Chief Economist David Seiders spoke before his association during a forecasting conference. His expectations for interest rate hikes have so far been right on the money. Homebuilders were told he "expects that the federal funds rate, which is currently one percent, will begin to rise in August and increase gradually to about three percent by the end of 2005. That would boost the prime interest rate, he said, but in terms of the availability and cost of loans the industry is heading into a very favorable financing environment."
Mr. Greenspan fully understands what the housing market has become and where it is headed. The mortgage drag on relative wealth has increased with the average fixed debt to income, now at a perilous 75/25. Homeowners have become exposed to far too much debt and the possibility that the value of their homes may drop as rates rise has the chairman worried
Those worries about this debt ratio has created concern among investors. The subject prompted a recent prime time, roundtable special produced by CNBC to address whether this is an opportunity or a warning sign.
There is a persistent belief that owning home provides more than shelter and, for the time being, substantial tax relief, but also a calculated measure of wealth as well. In my town of Portland, Ore., the average home price rose over $18,000 from the previous year putting the average starter home well out of reach of the average buyer.
The cheap money that has been a hallmark of this recovery. Over priced houses however have given way to clever financing. Those types of deals have made lenders far too profitable becoming a significant part of the market's overall yield. Currently, the capitalized weight of the financial stocks in the S&P 500 index has exceeded 25% signaling a market-wide disaster should investor realize what Mr. Greenspan has been so subtly suggesting.
The housing market is beginning to weaken. If the recent rise in foreclosures month over month continues as it did during this past month, investors do indeed need to begin to worry. The warnings Mr. Greenspan issued before the Senate Banking Committee last week were directed at Government Sponsored Enterprises. Fannie Mae and Freddie Mac have overloaded their portfolios with mortgages according to Mr. Greenspan, putting these lenders in a precarious position should anything change in the housing market. The net effect of any shift in sentiment in the housing market as rate rise and prices fall will be problematic for the government. GSE's are commonly believed to be backed by the good faith and credit of the federal government and those portfolios now total over $1.4 trillion.
Don't look for a bull market in equities to save us. No one can argue the fact that bull markets are created from dismal circumstances. Where there is value, there is the chance that more than one investor will spot it as seize the opportunity. Those opportunities are about to evaporate indicating that we are not looking at a market flush with enthusiasm. How large an influence on equities this adjustment in the housing market will be is as yet unknown.
Mr. Greenspan knows how this will play itself out. Expect profits to be less than Wall Street wants in the coming months as those four elements of healthy economy slowly stretch themselves to their limits.
That manageable interest rate environment is quickly evaporating making those predictions by Mr. Seiders of "favorable financing" becoming less likely in the coming quarters. Lenders will be forced to be even more creative as the interest rates increase. For now, rates seem to be holding steady.
Even with the retreat in oil prices this past week, no one can believe that the price at the pumps will follow. Gas has been priced into the marketplace and basically we will need to deal with it. Expecting ample and reasonably priced fuel to return exhibits a lack of understanding in how global demand over rides previous models of equal participation. Higher fuel prices also eat away at that home-based wealth effect.
Swelling deficits and the growing scourge that the alternative minimum tax are about to wage on a growing group of taxpayers will also undermine any possibility that those mortgages will ever be paid off. An accommodative tax base would have been the best starting point for the President to begin his second term. By choosing Social Security reform, currently the only assurance that Americans won't starve during retirement, instead of addressing tax reform and spending as Greenspan suggested will add to the problem as well.
That leaves pricing power. With our customers overseas diminishing as China expands its economic reach, our ability to grow into new markets will become more difficult. Take away the equity value in homes and many Americans will realize they no longer are living in their own personal ATM. This will effect spending across a wide variety of industries and that will remove any possibility of increased prices to cover slowing profits. Up to this point, many industries have relied on skeletal workforces producing at high levels to achieve shareholder returns. Pricing was supposed to be the way to sustain those expectations.
When the American public realizes that they more owe more than they are worth, a scenario that is about to unfold, they will pull back and do so quickly. By then, Mr. Greenspan will have retired and we will be left with his legacy and an economy undone.
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