Monthly Investment Commentary

July was another solid month for equities, as the S&P 500 gained 3.7%. Foreign stocks were up roughly the same amount, and small-caps put up big numbers, gaining 6.3%. Growth stocks did well versus value, but REITs – which some people consider to be a type of value stock – went against the grain, gaining 7.1%. Investment-grade bonds lost about 1% for the month. The cash and commodity futures weightings that caused our balanced models to underperform in preceding months contributed to their strong relative performance in July. Our equity model also beat its benchmark in July.

Thoughts on the Housing Market

Note: Much of the statistical information in this commentary comes from the Bank Credit Analyst, the Economist, and Ned Davis Research. In the interest of readability we have not specifically cited the origin of each statistic, but felt it was important to give credit to these sources in particular.

Virtually everyone is now talking about the housing boom of the last several years. Some call it a bubble, while others argue that it's a rational response to supply and demand. In getting our hands around the issue, there are several questions to address:

• Is there a housing bubble?
• If so, what would cause the bubble to pop?
• What would be the likely results of a housing crash or even just a significant slowdown in the housing market?
• What, if anything, should we do about this risk from a portfolio standpoint?

Is There a Housing Bubble?

With memories of the stock market bubble still fresh, the big increases in home prices in recent years is raising concerns among investors about the possibility of a “housing bubble.” But unlike stocks, which can be traded easily, and which lend themselves to clear valuation metrics, real estate at the national level is a collection of smaller markets that are highly sensitive to local supply-demand dynamics and economic conditions. So the answer to the question “Is there a bubble?” is not clear cut, especially at the national level.

It's certainly true, for example, that housing prices in many markets have had a big move upwards in recent years and this is reflected in the nationwide aggregate data. House prices, especially in certain larger markets such as New York, Boston, and much of California, have skyrocketed relative to household income and apartment rents. The use of residential real estate as an investment vehicle – often existing homeowners who leverage the equity in their home to buy second and third homes – has also increased. And the use of exotic and risky loans, such as interest-only or negative amortization mortgages (where payments are “artificially” low in the beginning but carry the risk of potentially big increases down the road) is rising along with home prices. These statistics, along with increasing media focus, certainly give the appearance of speculative mania. And in the end they could prove right. But the issue is not at all clear cut. There are other statistics that suggest a real estate collapse is unlikely.

While home price appreciation in some areas has far outpaced income, making home ownership increasingly less affordable, housing on average is still relatively affordable. The most recent readings from the National Association of Realtors' Housing Affordability Composite Index show that a median-income family has 17% more income than what is necessary to qualify for a mortgage on a median-priced home. This measure is a very important barometer of where the housing market is, since it incorporates mortgage rates and income levels, both of which are needed to understand homeowners' ability to service their home loans, which ultimately is more relevant than isolated data points like how much prices increased in 2004.

The popularity of adjustable-rate mortgages (ARMs) has caused concern among analysts that when interest rates rise, some homeowners will no longer be able to afford their mortgages, leading to an increase in defaults (which would then ripple through the financial system), or at the very least a big drop-off in consumer spending. The severity of such a problem would depend on the magnitude of the rise in interest rates, and on the overall condition of the economy and job market. It could be severe, but fixed-rate loans account for 78% of outstanding mortgages (more if you include hybrid mortgages that are fixed for a time before becoming adjustable for the remainder of their term), suggesting that the impact may not be as damaging at the national level as some fear. It is possible that regions such as California, where sharper price rises have led to wider use of ARMs, would be more impacted. But it is also possible that lack of supply in those markets – which has driven prices faster than in other areas – could also mitigate the impact of softening demand.

What Could Cause a Housing Crash?

As mentioned above, we are not convinced there is a nationwide housing bubble, and as such don't believe a crash in housing prices is imminent. However, the environment is constantly changing, and there are developments that could create problems. One of the most obvious would be a significant rise in interest rates. Higher rates would cause affordability to drop, which would soften demand both from new buyers and existing homeowners seeking to “trade up.” Defaults among the sub-prime ARM crowd would gradually pick up, and this would effectively increase the supply of homes for sale. So we'd see softening demand along with increasing supply, which Economics 101 tells us isn't good for prices.

Another catalyst for falling or flattening home prices would be economic weakness leading to a drop in general income or employment levels; in both cases, people would find it more difficult to service their existing mortgages or afford new homes. Finally, the cost of home ownership could become so much greater than the cost of renting that people increasingly choose to rent instead of own.

What Would a Housing Crash Actually Look Like?

The fallout of a full-blown crash would be bad, though probably not disastrous. There would be the direct impact on home prices and housing-related industries, as well as an impact on the broader economy. With respect to home prices themselves, housing prices in general have not dropped by more than a percent or two at the national level in housing downturns over the past 30 years. Rather than sharp falls over short periods, the pain of housing downturns often comes in the form of a number of years of flat or slightly declining home prices. Two caveats to this analysis are that 30 years isn't an especially long span (but it is one for which data is readily available) and there's a huge variation in price movements by region. For example, the housing recession that started in 1979 hit manufacturing-dependent states very hard, whereas California and New York fared far better. The reality is that home prices are strongly impacted by what's going on in their regional economy, and extrapolating to the entire country doesn't give an accurate picture. On average, however, it would be very unusual to see a huge decline in aggregate prices nationwide.

The impact of a housing crash – or even just a sustained slowdown – on the overall economy would mainly stem from consumer spending, which accounts for about 70% of our GDP. Consider the likely backdrop to a significant decline in home prices. If housing prices are a bubble, interest rates are the pin that could pop it. And higher interest rates would pose additional problems to consumers beyond just home prices. Variable rate mortgage payments would rise, as would the cost of servicing credit card and other consumer debt, taking money from consumers' pockets. And with fewer people moving, demand for durable goods such as home furnishings and appliances would drop. Big increases in home equity have also boosted consumers' ability and willingness to spend, so a rational conclusion would be that losses in home equity could have the opposite effect. Additionally, housing and its related industries are a big part of the economy, so construction companies and materials providers would suffer in a housing recession. Many of these housing-related industries (construction in particular) have greatly increased their hiring in recent years, and if the industry dried up, unemployment could pick up as those workers are laid off, exacerbating any economic weakness. It is worth considering that the magnitude of these effects will be a function of the severity of any decline, and that it might not even take an actual decline to bring about some or all of these effects. A sustained period of flat prices alone could essentially take away a nice tailwind that the economy has enjoyed for a number of years.

Another of the big concerns surrounding a housing crisis is the stress it could put on the financial system. Real estate lending makes up more than half of total bank loans. The obvious risk is that big price declines could cause lenders to retrench, and a recession-inducing credit crunch could ensue. Fortunately, banks sell many of their loans, so their exposure is much less than it used to be. Lenders would be hit, but the pain would be shared by a broader set of stakeholders.

There's a lot of uncertainty analyzing how all of these forces might play out. Even though we think a significant drop in prices at the national level is probably not in the cards, we still want to understand what the risks are, and what the impact of regional declines in economically important areas might be. A recent paper presented at the Federal Reserve Bank of Atlanta Conference on Housing, Mortgage Finance, and the Macroeconomy posited that for each 1% drop in housing prices, GDP could drop by 0.2%. Using that formula, if prices dropped nationally by 5% (which hasn't happened in the last 30-plus years), that might impact GDP by 1%. If that were to coincide with a pre-existing level of economic weakness, we could be pushed into recession, and as we mentioned above, some regions would get hit far worse than others. Still, while painful, this is probably not a disaster scenario.

What Impact Would A Housing Crash Have On Investment Portfolios?

The brunt of the damage to a diversified investment portfolio would probably be felt by equities. A material drop in housing prices at the national level would hurt the economy, and the earnings of most companies are at least somewhat impacted by the growth (or contraction) of GDP. The most economically sensitive sectors, especially those tied to homebuilding, would be the hardest hit. Bonds could rally on fears of the ensuing economic weakness, and the capital gains in bond positions would at least somewhat offset the damage to equities. But the most likely precursor to a fall in the housing market would be rising interest rates, so bonds would likely do poorly in the period preceding a housing collapse. It is very possible that over a 12-month time frame our model portfolios could approach or even exceed their loss thresholds if a major collapse in home prices came to pass.

So why aren't we changing our portfolios to provide greater protection? We are already well diversified and, at the end of the day, we don't view a nationwide housing crash as having a high enough probability, or being of sufficient magnitude, to warrant any specific portfolio moves, especially given that there is no obvious way to hedge against this scenario without taking on undue exposure to other risks. However, it is an issue that we will continue to monitor, and changes in the environment may cause us to adjust our thinking in the future. If that happens we will report back.

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