The Investment Journey

Real Estate Poses Risk

One of the ironies of the recent housing boom (boom is a kind word for rapid asset inflation that enriches investors and makes them believe they’re smarter than they actually are) is that, until recently, inflation as measured by the Consumer Price Index (CPI) remained in check. This kept interest rates low and helped send housing prices into the stratosphere of unaffordability.

Between 2002 and 2005, the CPI remained subdued — trending downward, in fact — in part because the “owner-equivalent rent” (the largest component of the CPI) declined because so many renters decided to become home owners. This increased apartment vacancies and capped rent increases.

Over the past six months, the lack of affordable housing, higher interest rates, and increased housing inventories have slowed the housing market. Scarcity promotes buying; abundance discourages buying. The result has been an increase in rents, rental housing demand, and the owner-equivalent rent component of the CPI.

American’s overinvestment in real estate represents a long-term risk to the economy. It may represent a more immediate risk if housing prices rapidly deflate. The trajectory of housing prices in some areas has gone from double-digit gains to low single-digit gains to small losses.

Real estate has played a predominate role in U.S. economic growth over the past few years. Each additional interest rate increase threatens to slow the housing market too quickly, risking a deflationary slide into recession. The jury is still out regarding whether this housing cycle will end with a soft landing or something harder. The hard-landing scenario would favor high-quality bonds, whereas stocks would suffer.

Rate Increases Nearly Finished

The Fed is well aware of the housing risks, and this partially mitigates the risks. The goal of Federal Reserve policy is to raise interest rates high enough to slow the economy sufficiently to cool inflationary pressure, but not so high as to trigger a recession. The current consensus of market participants is that the interest rate increases are nearly finished.

One potential risk in the next 6 to 18 months, however, is that the economy slows but inflation persists around 3% because of rising rents. This means that the Fed would be forced to raise interest rates higher than expected to 5.5% or 5.75%. If this happens, stocks and bonds would suffer.

During the past few months, stock and bond markets have been volatile as participants attempt to estimate the end of interest rate increases. Both the stock and bond markets believe that the Fed is almost through increasing interest rates. If you have been following stocks lately, you know it has been a yo-yo ride to nowhere.

Are World Events a Factor?

Events in the world may not have much effect on the overall economy.

The Middle East crisis is part of a long and tragic history of religion-related violence (That should be an oxymoron, but it is not). At present, I believe that Middle East instability is already imbedded in asset prices and, as such, does not represent a significant additional risk at this time. Obviously, if Iran obtained nuclear weapon capability the risk dynamics would change substantially.

The U.S. presence in Iraq, as well as Israel’s recent actions, may counter-intuitively mitigate terrorist actions by focusing the region on its immediate local problems. In other words, if your neighborhood is on fire, you are probably not going to spend a lot of time planning how to burn down your enemy’s neighborhood. (Admittedly, that may come later.)

Stocks Now Reasonably Priced

This decade has been difficult for large-company stocks, which have made virtually no gains in the past five years. For the past two-and-a-half years, stocks have climbed a wall of worry. In 2004 and 2005, stocks performed poorly for most of the year, saving their rallies for year end.

This decade looks to be one of the worst on record, based on the first five years. This means that the overvaluation of the early 2000s has been wrung out as earnings have recovered and advanced, but many stock prices have not.

Drug stocks have gone through more than five years of miserable performance, and in my view are now very attractive to buy. Big Pharma stocks like Merck, which performed very poorly after peaking in the late 1990s, now seem to be turning around. The drug sector’s negatives priced in, the PEs are low, and dividend yields are 2.5 times that of the S&P 500.

The good news is that the economy has recovered, as have earnings. Many large-company stocks are now reasonably priced, and corporations are in excellent financial shape. I am finding attractive stocks to buy. The past six months, in terms of buying and selling stock, have been quite active by MCS standards.

Bonds Are Reasonably Attractive

Bonds have defied the conventional wisdom of poor performance during the past two years as the Greenspan Fed started gradually raising overnight interest rates in early 2004. Long-term bonds performed better than expected in 2004 and 2005. It is worth noting that bonds helped save client portfolios from the painful losses that the stock market endured in 2000, ’01, and ’02.

Ten-year Treasury bonds have been range bound between 4.9% and 5.25%, currently 4.94%, as bond investors try to anticipate the economic slow down (remember, the Fed controls overnight lending rates between banks, and the Fed funds rate is currently 5.25%). An economic slow down would be favorable for bonds, as long as inflation declines with it. A slow down would not hurt stocks and could even lift stock prices, as long the economy does not slow too much.

With bonds, the bad news is higher interest rates depress the price of bonds. As a result, bonds in 2006 will likely turn in their worst performance in the past five years, down about 2% to 4% year to date. The good news is that bonds are reasonably attractive now. Lower bond prices mean higher future returns. We now have an opportunity to invest current cash and maturing bonds at higher interest rates.

High-quality bonds are reasonably attractive in the longer run (5 to 10 years) because the overinvestment in housing and attendant consumer debt, coupled with wage and salary pressure due to globalization (think layoffs at GM and Ford), set up a long-run deflationary bias in the economy.

Bottom Line

The housing market will be closely monitored for signs of rapid deterioration which, to this point, have not appeared. There is always something going wrong in the world, so don’t let it get to you. Stocks and bonds are reasonably priced, so I will be adding them to portfolios as client circumstances and opportunities dictate.

Remember: Between the beginning and the end is what really counts: the journey.

Be kind. Enjoy.