Eerily Reminiscent of the 2000s Rally

 | May 31, 2013 | 10:00 AM EDT  | Comments
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dhi

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tol

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gld

In recent days, I have been interacting with real estate agents who are informing me about how "on fire" the real estate market is in Southern California. Checking the value of my own home on Zillow, I found it up 27% in the last year -- and we don't even live in the really "hot" areas of Los Angeles, such as Malibu. My consternation grew Thursday during an idea lunch with my "cabal." (I'll have more on that Monday, including their best ideas -- I report on this group regularly). One among the cabal has reported that he is speculating in Hamptons real estate in New York, while another has said he is structuring a deal to put up spec townhouses near San Diego.

After years of Federal Reserve monetary promiscuity, I am constantly wondering when and how excess liquidity will make its presence known -- in which asset classes, and to what magnitude. A chart of the S&P 500 provides part of the answer, and perusing Zillow supplies the remainder. During our lunch my mind drifted back to the last time our economy crashed, and when a Federal Reserve chairman then unleashed massive liquidity to protect "the system." Those 2002 actions resulted in a multiyear stock market and housing rally. Is this "Groundhog Decade," with the same pattern repeating over and over each time I wake up?

If housing prices are in a brief upward "correction," I can live with the quick gains. But, as the actions of my cabal indicate, folks are starting to believe we are in a multiyear housing bull market. Here is why I struggle with that idea:

1. I can explain the 1980s housing bull: Mortgage rates declined from 20% to single digits. Since houses trade like bonds, a huge increase in prices was natural and sustainable at the new lower rates.

2. I can explain the 1990s housing bull: This came with rapid economic expansion with real wealth creation due to technology-driven productivity improvements, which naturally flowed into higher incomes, greater wealth and more buying power -- and rates continued to decline.

3. The 2000s housing bull is explicable in retrospect: Massive liquidity flowed into a corrupt mortgage system, in which overleveraged people could bid up prices. (Hmm, that sounds familiar -- student loans and college tuitions, anyone?) Of course, that false rally ended in tears.

So what would drive a housing bull market now? It can't be interest rates, as it had been in the 1980s. Rates are probably as low as they can go at this point, and have recently started backing up.

U.S. Mortgage Rates, May 2013

Economic growth is tepid, and median incomes are not rising.

Seasonally Adjusted Median Household Income

Housing is certainly more affordable now than it had been at the peak of the bubble, based on the ratio of average price to income. But the ratio is still well higher than the long-term average. Lower mortgage rates justify a somewhat higher ratio but, conversely, the falling income indicates that most people would need to stretch to buy right now.

Median Home Price to Median Income Ratio

The new rally just doesn't feel real to me. Rather, it feels like the start of a repeat of the 2000s liquidity-driven bull run. Now, to be fair, there are some factors that indicate the run could last a couple more years. For one, housing starts are still at all-time lows, and they have room to bounce back to "normal" levels.

Housing Starts Per Million U.S. Citizens

The housing stocks are still off the bubble highs -- but they are not that far off, and I question whether they should go back to those highs any time soon. Or, a run to the highs might also correspond with a maximum phase of a new bubble. See the below charts of Toll Brothers (TOL) and D.R. Horton (DHI).

Toll Brothers (TOL) -- Daily

D.R. Horton (DHI) -- Daily

I am picking on housing here, because my real issue is with Fed promiscuity. I do not believe easy money solves the structural problems holding back the U.S. economy. I'm talking about the mass obsolescence of certain skill sets resulting from the 1990s technology revolution, or the indentured servitude -- in the form of unmanageable student loans and immoral college tuition rates -- with which the Baby Boomers are shackling the Millennial generation.

I do think easy money will do in 2010 to 2015 what it did between 2002 and 2008. That is, I believe it will again leak out into various asset classes, causing an artificial wealth effect and inflation. Ironically, we can see now why real estate is a great inflation hedge -- so maybe my speculating friends are not so wrong after all. I am protecting myself with some gold (via SPDR Gold Trust (GLD); with ownership of staple businesses that have pricing power, such as food or tobacco companies; and with some diversification into other "hard currencies."

I definitely would not short any housing-related stocks here, but I would just be very careful on the long side. The volatility creeping into various markets indicates a vigorous bull-bear battle is starting to form, which usually indicates a turning point in markets -- whether to the upside or to the downside.

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